Investing in fixed income markets has produced modest returns over the past few years amid a prolonged period of low yields and narrow credit spreads. During this period, the Invesco Perpetual Corporate Bond Fund was positioned defensively in terms of credit exposure, as we felt that credit markets were fully valued with only limited upside potential. Credit exposure in the fund was reduced in favour of gilts, and within the corporate bonds that we held the maturity dates tended to be relatively short. Although we maintained some exposure to high yield, this was at its lowest level since 2004. This reflected our concerns that the extent of leverage in financial markets was too high and that credit spreads were too narrow.
This strategy proved beneficial as last summer saw subprime-related turbulence engulf credit markets. As a result we saw a sharp fall in short-dated government bond yields and a steepening of yield curves, a dramatic widening of credit spreads and continued pressures stemming from the difficulties faced by financial structures and leveraged institutions. At this point we began to see value in riskier markets.
Recent weeks have seen a raft of poor US economic data coupled with a sombre outlook for the US economy from the Federal Reserve. Therefore, it is not surprising that a number of investment banks now are making a US recession, albeit a mild one, their central view. However, we feel that a lot of this bad news is already priced into government bonds, particularly at the short end. The two-year US Treasury yielded 1.50 per cent on 6 March, down by over 150 basis points year-to-date and down by 3.6 per cent from its peak last summer. We believe that this backs up our view that there is already a considerable amount of poor economic news as well as further Fed easing priced in. Therefore, given that government bond yields have already fallen such a long way, further significant declines are unlikely in our opinion.
Credit markets on the other hand are now offering compelling value, having been buffeted by a range of problems emanating from the banking sector. The substantial US subprime-related writedowns suffered by investment banks have triggered a prolonged and significant reduction in leverage and a general repricing of credit risk.
This repricing has been exacerbated by the unwinding of a range of complicated investment vehicles (SIVs, CDOs, etc), with forced selling of the underlying assets. With this forced selling driving down valuations even further, mark-to-market losses have increased, putting additional pressure on the viability of other financial structures.
In addition, the forced selling has led to a further widening of credit spreads. Spreads that we judged were starting to become more attractive in November and December are even wider now. In many cases, they are pricing in a probability of default that seems unrealistically high to us. Right across the rating spectrum, credit markets have become increasingly illiquid and corporate bond spreads have widened almost indiscriminately.
Comparing conditions in credit markets now with those of previous periods of tension – 1991, 1998, 2000 and 2002 – we think that conditions now are as distressed as they have ever been. Recently we have seen a process whereby valuations in some sectors have moved significantly out of line with fundamentals. The risks involved in investing in credit markets have clearly increased over the past year, as the pending economic slowdown will result in a tougher operating environment going forward. However, for those investors who are prepared to look beyond the current problems, there is compelling value both on a relative and increasingly, on an absolute basis.
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The Invesco Perpetual Corporate Bond fund aims to achieve a
high level of overall return, with a relative security of capital. The fund has been co-managed by Paul Causer and Paul Read since 1995 and is designed to be managed through the market cycle.