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LTRO lifts sector

Chris Salih assesses an upturn

Having enjoyed once-in-a-lifetime returns in 2009, the past couple of years have seen UK corporate bond funds sit in the doldrums.

Strategic bonds have superseded UK corporate bonds as the default choice for fixed-interest investments after fears of a bond bubble. Statistics from the Investment Management Association show in 2009, the UK corporate bond sector saw almost £6bn in net retail sales, falling to £504m in 2010 and £248m in 2011.

Many UK corporate bond funds looked unattractive investments last year as concerns about liquidity grew due to the sovereign debt crisis in Europe but the long-term refinancing option appears to have changed the landscape for the sector.

On December 21, 2011, the European Central Bank instituted a long-term refinancing operation of three-year loans at 1 per cent interest to European banks. Loans totalling £480bn were announced to tackle liquidity concerns. In February, the ECB introduced a second round of loans, with over 800 banks taking part.

The IMA UK corporate bond sector became the best-selling sector in January this year with net retail sales of £303m.

Kames Capital investment-grade bond fund manager Euan McNeil says the LTRO effectively kicked into the long grass the idea of a bank being knocked over on liquidity issues and bred confidence into the market.

He says: “It rubberstamped the ability for the Euro banking system to be able to fund itself. As 2011 moved on, concerns increased on Europe becoming a tail-risk event to a real risk event. It has now gone back to tail risk.”

McNeil says he took advantage of new issuance in the corporate bond market, which had fallen in the past three or four years. He says there was lots of attractive sterling, non-financial issuance in January and he used the opportunity to re-risk the portfolio.

He says: “We bought utility paper courtesy of RWE in Germany and Dangas in Denmark. Both came at significant concessions. There was stress at that point and you would not get the same premiums or concessions now.”

Ignis corporate bond fund manager Chris Bowie is not so confident on the longer-term outlook. He is negative on credit and specifically bonds as he says quantitative easing will eventually create enough inflation that bond yields will have to rise to address the risk but he does believe inflation will continue to fall this year.

He says: “We are defensive and underweight banks. The LTRO has improved short-term liquidity but not solvency issues and we remain negative on the sustainability of the eurozone over the medium to long term.”

Bowie prefers secured bond and fixed-rate asset-backed securities, highlighting the likes of Sainsbury’s and Tesco’s secure bonds or utilities secure bonds, as there is physical backing behind the cashflow. This means if a company gets into trouble, the bondholder has no trouble as they have physical assets as a recourse.

He says: “We are targeting A- to BBB+ bonds. There are some BBB- but they have physical assets behind them so they are more secure. Spreads are reasonably attractive at about 2.5 per cent over gilts but yields are not, particularly on the long term where we have negative real yields which are not sustainable.

One of the few funds to perform over both a one and three-year timeframe is the Baillie Gifford investment-grade fund managed by Stephen Rodger. He likes the current market, pointing to “lots of variability and disparately priced bonds”.

He says there are lots of opportunities, particularly for a stockpicker with a smaller fund such as his own. He was recently busy in the dollar market, having bought Li & Fung, which does the sourcing for Walmart.

Rodgers says people often associate banks too closely with financials. He says there are opportunities in the financials sector such as Man Group, which he recently added to his portfolio. He tends to invest in the BBB market, with a focus on the top end of the high-yield market and the bottom end of investment-grade.

One of the biggest funds in the sector is the M&G corporate bond fund, managed by Richard Woolnough. He says the bailout package for Greece and LTRO have both aided the UK corporate bond market.

He says bonds at the lower end of the investment-grade market performed best in February, with BBB-rated corporate bonds returning 2 per cent. High-yield bonds returned 4.4 per cent on average in February.

Woolnough reduced his portfolios duration in February from 6.4 to 6.1 per cent. He says: “Government bonds remain unattractive at current levels. In addition to selling 10-year gilts futures, we also sold five and 10-year Treasury futures and five and 30-year bund futures to reduce the duration.”

Rodgers says: “The opportunities are there. We live in exciting but uncertain times where politicians are still heavily engaged in the economy and that means things can change quickly.”

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