MEAN REVERSION

Corporate bond managers think their time has finally come to lead the pack in terms of returns. Paul Farrow tests the downside

Corporate bonds are being seen in a whole new light – not just as safer haven, but also an asset that has the potential to generate double digit returns over the next few years.

Deutsche Bank has gone as far as to proclaim that bonds have fallen so far that the next 10 years could prove to be the ‘Decade of Credit’. It reckons that annual returns of more than 10 percent are a realistic possibility even if defaults increase. “Bonds have more to gain than other financial assets from ‘mean reversion’, aka a return to historical averages,” says Deutsche analyst Jim Reid.

Financial advisers and fund managers are falling over themselves to get a piece of the action. Jim Leaviss, bond fund manager at M&G has just topped up his pension splitting the new investment two-thirds to a third in favour of bonds to equities. Meanwhile, equity die-hard Mark Dampier from Hargreaves Lansdown has, for the first time, bought corporate bond funds for his Sipp.

Corporate bond fund managers have had a devilish time of late but now many analysts reckon this is a once-in-a-lifetime buying opportunity – the average fund is down by more than 10 per cent over the year.

The reason bond fund managers are feeling bullish again is because of spreads – they are back to levels not seen since the Great Depression. Spreads have widened drastically – it was not long agthat they had narrowed to unforeseen levels, which had made them a no-go area.

Go back to 2007 and the spreads of BBB-rated bonds were 1.5 per cent above government bonds, today the spreads are around 6 per cent. This gives the bond ample opportunity to deliver a capital return when confidence returns to the market and spreads narrow once more.

Spreads are at record levels because credit markets have been hit by the substantial forced selling. This has resulted from the unwinding by levered investors such as hedge funds and banks. The collapse of Lehman Brothers was a pivotal moment – it not only intensified this trend but also led to a collapse in confidence and a seizure in the credit and money markets. “The effect of forced selling on pricing has been dramatic. Investment grade spreads in sterling are now more than twice their previous all-time wides of 2002,” says Paul Causer, the highly regarded fund manager at Invesco Perpetual.

He adds: “The data shows that, given the size of the yield advantage of credit relative to government bonds, a third of all investment grade issuers and over half of the high yield market would have to default over the next five years before government bond markets provided comparable returns. In investment grade this would be a rate that is 14.5-times worse than markets have previously experienced.”

Causer is one of the most highly rated bond managers in Britain and he has been cautious for some time – his shift in sentiment has not been missed by advisers. But today he is in a bullish mood, particularly with bonds that are asset backed.

“A good example is pub group Punch Taverns, which is principally financed by debt, of which the best-rated AAA bonds have performed well, but the riskier BBB bonds have been crushed down to around 60 pence in the pound. With AAA bonds representing around a quarter of all debt, the company would have to lose three-quarters of its assets before AAA investors started to suffer. It’s a position I’m happy to maintain.”

Experts argue that historically cheap valuations in many bonds and the fact that fixed income markets have already priced in a full-scale depression, not the expected recession, provides investors with a terrific entry point. Bond prices are pricing in default rates of 35 to 40 per cent – yet, looking back over the years, Henderson Investors reckons the worst case scenario default rate for investment grade bonds during a recession has been 2.4 per cent.

John Patullo, manager of Henderson Strategic Bond fund, says: “Some bonds, such as Imperial Tobacco, are yielding 9.4 per cent – a small narrowing of spreads will double your return. Even if spreads narrow significantly you will break even because of the yield you are getting.”

Patullo admits he anticipated the bond recovery too early last year – the collapse of Lehman Brothers threw a big spanner in the works – and his performance suffered as a result. But he now believes the worst is behind us. He has been sitting on 20 per cent cash in his portfolio – most of which will be used in the next two months.

“We will be looking to invest some of that cash between now and Christmas. Just before the end of October, the US reduced interest rates. It wouldn’t be surprising if in a year the UK base rate is half its current level,” he adds.

Peter Hicks, head of IFA channel at Fidelity, is another bond bull. He says: “Overall, the Sterling corporate bond market is yielding nearly 9 per cent – and that’s after markets have priced in a full blown depression, rather than simply the recession experts anticipate. Our fund managers rightly expect volatility, so a bond fund’s yield and capital levels will ebb and flow a little but, with interest rates at 3 per cent (and falling), companies now have the best incentive in a long while to borrow money from bond investors which is a positive outlook for fixed income.”

But the bond story is not clearcut, despite interest rates predicted to hit zero. Much of the market is illiquid and many bond funds have exposure to Tier 1 bank debt, which they can’t offload. Many bond managers are using credit derivatives to offset any bond turning bad – this defence mechanism isn’t free and the cost of the derivative wipes out any upside.

It is notable that Theo Zemek, the former M&G and New Star bond supremo is not talking up the new fund she has just inherited at Axa. The fund is exposed to some poorly performing bonds, which she is trying to dispose of. But the liquidity issue is not making it a quick fix and she would not advise investors to pile in just yet.

There is also a school of thought that the supply/ demand effect will work against bonds. Given the dire straits of the economy it is widely expected that there will be a splurge of gilt issuance by our cash-strapped Government – which will mean there will be no shortage of instruments to choose from.

John Anderson, a corporate bond manager at Rensburg, admits that at first glance, the outlook for bonds appears to be “most propitious”, with interest rates falling and the extra yield over government issues offered by corporate bonds (‘spreads’) standing at record levels. “It is no surprise that many bond managers are once more peddling their wares and telling investors that all bonds represent outstanding value,” he adds.

He warns that there are many reasons why potential investors in the bond asset class still have to tread carefully.

“The first is to point out that despite all the traumatic events in the markets over the past two months (the extent of which should have seen government bonds rally as investors sought safety and anticipated lower interest rates), the yield currently on offer from 10-year gilts (around 4.5 per cent) is barely changed on where it was at the start of September. If you had invested in longer-dated issues over this period then your return would actually be negative,” he says.

“Another issue to remember with non-government bonds is that the same factors that are leading us towards lower interest rates are those that will make life extremely difficult for the whole of the corporate sector, with casualties almost inevitable. In such an environment, investing in corporate bonds, although highly lucrative for those who judge it correctly, will be like walking across a minefield.”

While Anderson admits they offer value in the medium to long-term it is not a one-way bet and some funds will be better positioned than others to take advantage. This is a quandary for employees as the bond offering on a GPP scheme, for instance, may include a fund exposed to the riskier sectors. Many bond managers jumped into bank-related bonds prior to Bear Stearns and did not foresee the Lehman collapse.

The so-called “minefield” has not deterred trustees from making the switch. The latest annual survey from the National Association of Pension Funds (NAPF) has shown that large institutional pension funds are continuing to move their assets out of equities and into other investment classes. Jason Walker at AWD Chase de Vere points out that while mutterings have abounded on the bond opportunity since late August, corporate bonds have also underperformed over the past two months. “Some corporate bond funds have been dropping 10 per cent in a week! The asset class to be in over the short term would be gilts,” he says.

Michelle Cracknell at Skandia is also reluctant to change tack on communication strategies. “I have also been hearing people talking up corporate bonds, but I would not advise trustees or employers to communicate this message to members.”

Cracknell says that members should always be in a portfolio that meets their risk appetite and term of investment – and that corporate bonds would “undoubtedly” form part of this portfolio anyway. “Timing the market is impossible and members should not be encouraged to try to make highly tactical asset allocation decisions. Tactical asset allocation is really for professional fund managers.

“Members should be encouraged to have a long term investment strategy. In my experience, members tend to stay in equities too long when markets are going up and then are reluctant to sell when they fall in value. The simple formula basis of lowering the risk by switching to lower risk asset classes each year as you approach retirement disinvestment date is the best approach.”

Such caution will not bother bond managers who remain convinced that their time is coming. Many reckon that we are past the worst and that the risk of another large bank failure has declined. “Government action has been swift, co-ordinated and substantial,” says Causer.

They argue that markets are forward-looking, so with the recession already priced in, investors are already starting to think about the recovery, and where they want to be in twelve months.

Patullo asks: “In an environment of falling interest rates do you want to be stuck in floating rate, lowreturn cash instruments, or would you rather take the fixed yield available through bonds? When interest rates are on a downward path, fixed income is the place to be.”

That is as maybe, argues Cracknell, but she is wary of employees jumping on the bond bandwagon. “Herding is probably the strongest instinct in investments, so if people pile into corporate bonds they will become overpriced,” she says.