Select for security
Look back to 2009 and 2010 and the game was all about how much credit risk exposure you could get. Those who got most got the highest returns. Now we are back to a situation where most corporate bonds are fair value at best. Two years ago was a once in a lifetime opportunity and most of that has run its course but if you are smart enough there is still money to be made.
Companies like Tesco, Marks & Spencer and utility companies now have the same yields and credit spreads as five years ago, so there is no excess profit there.
But there are selective opportunities in some financial institutions that offer reasonable returns. Nationwide Building Society is one, with returns of 8 or 9 per cent on its subordinated debt, while the senior debt is 6 per cent, which is pretty good value. Standard Life also offers similar high-single-digit yields on its subordinated debt.
We also like parts of the market where we have security over assets. We like British Airport Authority, which offers security on Heathrow and Gatwick airports. BAA is paying 2 per cent on top of government bonds. Angel Trains is playing 2.5 per cent over gilts, secured on rolling stock.
Government bond yields have come back from around 2.5 per cent last August and are now at around 3.5 per cent but we struggle to see them rise above 4.25 per cent.
The Bank of England will have to raise interest rates soon but we think rate rises will be slow because the fundamentals of the economy remain in question. The Q4 2010 GDP figures were very weak and we think this year’s Q1 results will not be significantly better.
Look under the bonnet
Shifting out of the UK bond market was a popular move at the end of 2010. We have been underweight in the UK but now we have gone neutral and if we were not concerned about inflation we would think it would be one of the better places to be.
If inflation and interest rates go up, that is not good news for bonds but that is already priced into the market. We are less concerned about inflation than we were three to six months ago. The aim of the game is to make your move before everyone else and the inflation story is already played out.
Generally, we expect to see medium and longer-term bonds doing rather better than short-term in future, so the yield curve will flatten rather than all yields go up. So our strategy is more about yield-curve positioning rather than absolute sectorsor industries.
When you look at spreads and yields, they look dull on the face of it but under the bonnet there is still a lot of relative value investing we can do. In particular, there is still a lot of dislocation in “off the run” or non-core bonds, so we have been investing in floating-rate notes in bank debt, which give some level of inflation protection. We have also been investing in callable floating-rate asset-backed securities, where the quality is there.
We also like cyclical-based companies, such as those digging things out of the ground, because we think there is a trend of going into non-cyclical defensive bonds right now. We are not being contrarian for the sake of it but if it looks fair value, you are probably not going to do that well. It pays to stay ahead of the game.
Defense tactics to play high-yielders
Why should sterling bond investors stay put in 2011? Overall, we believe there is still quite a lot of value built into pricing. UK bonds are pricing in a rapid increase in interest rates that might not happen and corporate collapses that may not happen. It is very much a valuation story on both fronts.
Corporate bonds are attractive because corporate spreads are still quite wide. Since the bottom of the recession, there has been a steady recovery and spreads have halved since the worst point in 2009 but they are still double the level they were at the end of 2007, particularly at the longer end of the curve. We think single A and triple B are attractive and there is still scope for a bit of capital yield as well.
The UK has a problem in that inflation is uncomfortably high but we do not see the conditions in place to lead to anything like a 1970s-style inflation situation.
The inflation story is not as bleak as it may look at first glance. The economy as a whole has a problem and the growth versus inflation trade-off has got worse over the year but I think that lower interest rates rather than the higher yields will be more likely in the future.
Although inflation is in the background, we will not get significantly higher interest rates in the UK and anyway we have already got interest rate increases priced into the bond market.
The ideal target for us is high-yielding but fairly defen-sive sectors, such as telecoms companies, and we have just taken positions in a train rolling stock company.
We like cashflows that are predictable and defensive because if we have a slowdown in the economy, they will remain steady, which is why we are avoiding discretionary consumer spending companies.
Credit spreads can still offer value
Inflation has been the subject of a lot of media attention, with a headline CPI rate of 4.4 per cent and RPI at 5.5 per cent. Against a target of 2 per cent, that is high. We concur with the majority of those on the Bank of England monetary policy committee who say the drivers of that inflation are external. We have seen a 25 to 30 per cent fall in sterling, rising prices for commodities, food and fuel and increases in taxation all adding to pressure.
If that had fed into secondary pressures we would be more concerned but we are not seeing it feed through to wage inflation in a significant way. Provided there are no external shocks, inflation should come down towards the back end of the year.
Unemployment is at 8 per cent and we are not expecting to see it come down for some time. That means a prolonged period of sub-trend growth, which should not be bad for bonds, provided inflation comes down.
Credit spreads in the mid-1990s, after the recession of the early 1990s, were a quarter of what they are today. In 2009 and 2010, there was a lot of low-hanging fruit and the easy returns have been made but some credit spreads still offer good value.
We like insurance companies, as they are safer and more transparent than the banking sector which faces a lot of regulatory hurdles.
Banks have to deal with the higher capital requirements of Basel III and the risks of peripheral Europe, where some could be forced to take losses.
We see a lot of value in securitisation and in telecoms. We are not attracted by utilities because while the quality is there, the returns are not high enough.
We believe there are good opportunities out there and, with active management, corporate bond funds should post good returns this year.