Darius McDermott: Where to find value in corporate bond markets

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After a bull run of more than 30 years, I have been bearish on bonds for some time now. The prevailing environment that has been so supportive for so long has started to present a real risk to the asset class. When the tables turn – as eventually they must – it is an area of the market that will come under pressure.

However, that has been the case for a few years now, and conditions continue to hold. In fact, where you might have thought there was really only one way for interest rates to go, lo and behold European and Japanese central banks have both moved into negative territory.

Could the Bank of England go the same way? We cannot rule it out entirely. In the near future, negative rates would be a positive for bonds as their yields would fall and prices would rise.

True, the US raised rates once at the end of last year but, given the subsequent market turbulence and sluggish economic outlook, further rises do not look imminent. The Fed may even have to reverse its move in the short term.

So the bond “party” could continue for a while longer. But this raises the question: where can investors find the best returns with an acceptable level of risk?

Over the past year the IA Sterling Corporate Bond sector has fallen along with other asset classes and the average fund is down about 3 per cent. However, this has opened up some interesting opportunities. Just as investors seek to pick up good-quality buys on the cheap when stock prices fall, the same can be done in the bond space.

Risk elements

Returns from corporate bonds are driven by two elements: interest rate risk and credit risk.

Interest rate movements are driven by inflation expectations, which are influenced by the economic environment. As we have iterated, these are all currently supportive of fixed interest investments. Aside from some prudent management of bond maturity dates, there is little corporate managers can do to influence these factors.

So let us instead focus on the second element: credit risk. At this late stage of the cycle, investors want to have a reasonable degree of confidence that the issuer borrowing money will use it responsibly (ideally for purposes that will grow their business), will take the interests of its shareholders and bondholders seriously, and will have a good chance of being able to repay its debt.

The recent example of McDonald’s issuing US$10bn in fresh debt as part of a plan to pay US$30bn in shareholder returns over the next few years reflects a worrying trend. McDonald’s is by no means the only guilty party.

With this in mind, when it comes to buying up corporate debt, it is critical fund managers identify the companies operating sensibly amid the mire.

Banks have been under scrutiny again in recent weeks, with the negative interest rate phenomenon sparking a new wave of sell-offs as investors worry that continued low rates will seriously squeeze profit margins and perhaps force riskier lending practices. In particular there have been concerns about banks’ contingent convertible bonds: the riskier end of their capital structure.

Opportunities

As mentioned, though, opportunities can be found in the price dips. TwentyFour Asset Management head of distribution John Magrath cites Lloyds Banking Group as a good example. Its dramatic reduction in impaired loans, and the improvement in its income and capital structure since its bailout, is yet to be fully reflected in its bond prices, he says.

Sell-offs have created value in other financial sub-sectors too, according to Royal London Corporate Bond fund manager Jonathan Platt. He says yields in the insurance sector are very attractive at current prices. The likes of Prudential, Legal & General, Axa and Aviva have considerably de-rated over the past six or seven months and the fund has taken the opportunity to increase its insurance exposure.

Platt also believes the market rout has created value in utilities and hybrid bonds.

So how does this all help investors with a longer-term outlook? Unless central banks surprise us by introducing faster or higher-than-expected rate rises, while the outlook is not great for bonds, it is not disastrous.

As and when rates eventually do rise, we can expect some capital losses. Ideally, then, you are looking for fund managers that can deliver a high enough yield to compensate for these price falls and still come out ahead, while having the wherewithal to do their due diligence on each and every investment and make sure they are not accepting too much risk. A delicate balance in this sector.

Funds we like include the Royal London Corporate Bond, M&G Strategic Corporate Bond and Kames Investment Grade Bond.

Darius McDermott is managing director at FundCalibre