Investment-grade corporate bonds continue to offer exceptional value, particularly versus Government bonds and, perhaps less so, versus high yield. However, it is ambitious to expect a smooth ride from the asset class – many bonds are trading at cheap prices but it would be too easy to fall into a value trap and over-burden a fund with credit risk.
I would counsel investors to build up their corporate bond exposure through a mix of defensive plays and, to a lesser extent, more opportunistic ones. Given the uncertain times, I feel this approach will encourage outperformance in a credit market rally but also retain sufficient defensive properties to protect against any worsening in the economy.
For example, I like many bonds from staple names in traditionally safe sectors. In recent months I have bought bonds in Pfizer, Imperial Tobacco and Carlsberg, and while some of these bonds offer spreads over gilt yields of 5 per cent-plus, I believe they are good credits that can withstand the most fragile of economic scenarios.
At the other end of the risk spectrum there are many out-of-favour names at cheap prices. Specialist financial 3i and pub group Enterprise Inns are two good examples.
Deflation is the most immediate risk but I am aware of the potential for quantitative easing and upward pressure from rising commodities leading to higher inflation in the medium to long run.
Investors may consider seeking inflation protection from fixed income and, at the moment, US treasury inflation- protected securities. Resource and mining-related securities, such as AngloGold, also look like good bets.
However, given current credit spread levels, I believe there is already a degree of inflation protection built into corporate bonds – and investors should remember inflation can reduce default risk and help tighten credit spreads as rising prices help companies repay fixed debt.
I have long been cautious about the financials sector. But since the beginning of the year, I have started to see pockets of value, particularly in subordinated bank debt trading very cheaply. Lower and upper-tier-2 bonds look better value than tier-1 debt.
In fact, I remain cautious of the latter because this type of bank bond faces two obstacles. First, the regular interest payments to bondholders, known as coupons, can be deferred and, second, there is regulatory uncertainty surrounding repayment of the initial loan or principal.
An interesting development is the role of non-sterling bonds. I usually like them for their diversification benefits but there are now two more additional technical reasons to consider them. First, they can insulate an investor from weakness in sterling. I am aware that the UK economy is susceptible to swings in investor sentiment, that the bank-ing sector has a disproportionately large amount of foreign liabilities and the UK Government Budget deficit is deteriorating sharply.
In a scenario of currency weakness, there is also likely to be weakness in sterling bonds (both gilts and corporates). Therefore, it makes sense to look at non-sterling bonds (which may indeed even be issued by UK companies) and hedge them back to sterling.
Second, there are still a lot of valuation anomalies that clever trading can exploit. Banks and hedge funds previously used leveraged capital to iron out these discrepancies but, now they have exited credit markets, there are large distortions in the price of bonds across currencies. These spread differences are sometimes as wide as 5 per cent.
I advocate an approach focused on diversification and value – not just at the bond level but in all strategies investors apply.
Ian Spreadbury is Fidelity sterling bond fund portfolio manager