Bond cliffhanger

After a run of good returns, opinions are divided on where corporate bonds go next. Sonia Speedy investigates

Corporate bond funds are still on the best seller list, yet there is talk the spike in yields recently enjoyed is coming to an end. But while the hyped up corporate bond party may be coming to an end, it does not mean it is time to abndon them altogether.

In July, sterling corporate bond funds were the best selling UK domiciled fund sector for the ninth month in a row, Investment Management Association (IMA) figures reveal. The sector saw inflows of £467 million in net retail sales, compared to the UK corporate bond sector seeing outflows of over £100 million in July 2008. Total funds under management for this sector was over £39 billion in July this year.

The corporate bond sector has been enjoying its time in the sun since the global credit crisis took hold last year and investors ran for shelter in fixed interest products. Low interest rates at the bank have only served to further enhance the popularity of corporate bonds. However, confidence in markets generally is picking up again and with it investors’ appetite for risk.

Corporate bonds reputedly offer the benefits of a low correlation to equities and lower risk. However, if a corporate bond does default investors risk losing their money, so it is no straight swap for cash at the bank.

Barclays Wealth fixed income strategist Vanshree Verma says it is recommending clients hold a neutral credit position in their portfolios.

“The easy money via a long beta exposure has been made, and it’s likely to be a slow grind from here on,” she says.

“We believe the downside and upside risks are more balanced now. Investors need to be more selective while investing in credit at this point.”

Spreads, which reflect the difference between gilt and corporate bond yields, have come in a long way since the peaks seen in the first quarter of this year, says Standard Life Investments’ head of credit Andrew Sutherland. A high spread means high risk, while falling spreads indicate that corporate bonds are outperforming gilts in capital terms. The UK index spread had reached +450 basis points (bps), but is now at +230, Sutherland says. Previous highs included in 1999 – around the time of the Long-Term Capital Management hedge fund collapse and the fall-out from the Asian crisis – when spreads were 140 bps.

Worldwide Financial Planning managing director Peter McGahan says the markets had priced in defaults on corporate bonds “equivalent to armageddon. Naturally quantitative easing and low interest rates have helped the economy and Armageddon was averted. So with interest rates plummeting corporate bonds became very attractive,” he says.

However, McGahan also believes it may be time to reduce exposure to this sector over the coming months, citing the threat of inflation and higher interest rates.

Gore Browne Investment Management partner Simon James is another who believes the best days for corporate bonds may be behind us. The sector rallied substantially in the short term, so that even the bulls would not be surprised if it pulled back now, he says.

“The lowest grades have rallied most strongly, but even high grade corporates have done very well. All this despite record issuance of corporate bonds and Government debt,” he says.

James suggests yield spreads are now back at pre-Lehman levels normally seen during recessionary periods. This makes corporate bonds look fair to reasonable value – rather than very cheap as they were previously.

Sutherland, meanwhile, sees a buying opportunity in the very short term. He says the market has absorbed a lot of corporate bond issuance from companies replacing bank debt with corporate bond debt as a result of banks being unwilling to lend directly any more.

“Summer has seen the issuance slacken off – holidays and the like – and there may be an opportunity for credit to retrace some of the gains as the issuance resumes. We think this is a buying opportunity,” he says.

Looking to the medium term Sutherland sees scope for spreads to come down to long term averages.

“If gilts continue to benefit from the interest rate outlook and quantitative easing, then this means investors can continue to look forward to some more capital gains and high sustained income,” Sutherland says.

James believes the medium term will bring anxiety about the normalisation of global economic policy and whether policy makers have done too little or too much.

“In such an environment I would expect investors to look for a higher risk premium and thus spreads should widen at that stage. High grade issues should outperform other credit during this period,” he says.

Sutherland believes gilt yields will have to move higher in the long term if quantitative easing is unwound and recovery comes through, bringing with it higher interest rates and inflationary pressures.

“This is when capital values of corporate bonds will come under pressure. As gilt yields move higher then yields on corporate bonds will move higher in tandem,” he says.

James believes corporate bonds yields look attractive long term especially as base rates are likely to remain low for at least the next two to three years.

So is it time to get out? Verma does not believe investors should sell-out. She says corporate bonds still look attractive when compared to Government debt and could stay “range bound” or even improve to an extent.

James says: “A sell-off to take profits must be on the cards, but I would be surprised if there were to be substantial weakness in the absence of much higher default rates. Currently banks and other institutions seem keen to avoid defaults where they can.”

He suggests possible triggers for a corporate bond sell-off include a sell-off in equities; an end to quantitative easing style activities; a sharper increase in defaults; or a shift from the more benign view of economic prospects to more inflationary or deflationary expectations.

McGahan adds that quantitative easing has still not pushed down the cost of borrowing, hence borrowing via corporate bonds is still cheap – a factor that makes them look good value for the time being.

Baronworth Investment Services director Colin Jackson points to the diversification benefits of investing in a corporate bond fund rather than individual bonds. He adds that choosing a good corporate bond is not as straightforward as it used to be, particularly since the highly rated Lehman Brothers went “bust”.

James too believes stock selection is essential. “Credit availability is likely to remain tight for some time and weak balance sheets will be stressed as a result,” he says. He suggests picking issues that have good balance sheets and excess cash flows, or managers of funds that are seeking this.

Verma says the risk of default is key for speculative grade credit, suggesting we are likely to see defaults peak at the end of this year, or in the first quarter of next year. “Duration risk could also come into play as rates are at all time lows and as central banks tighten policy, corporate bonds could suffer, especially if spreads don’t decline enough to compensate for it,” she says.

McGahan cautions against buying corporate bond funds that use a lot of complex instruments as well as normal corporate bonds, saying it is an added risk that few understand.

Investors also need to be aware of where fund charges are taken from, Jackson adds. While some take the annual management charge (AMC) out of yield, others take it out of capital, meaning that a percentage of the capital investment is eroded each year as a result. Advisers say a typical AMC for a standard investment grade corporate bond fund is around 1 to 1.5 per cent.

Sutherland sums up the arguments for staying versus exiting corporate bonds by saying that it is a good time to get out – just as long as you have something better to do with the money.

“Equities? Cash in the bank? But equities are much higher risk, banks rates are zero, so…”

It looks like it is far from over for corporate bonds just yet.

ADVISER VIEW Less exciting times ahead

Martin Bamford, joint managing director, Informed Choice

“Bonds are still quite attractive”

Investors wanting to make a quick return and benefit from the “exciting” corporate bond yields of last autumn, are too late, according to Informed Choice joint managing-director Martin Bamford. But he too does not believe that corporate bonds should be cast aside as a result, believing they still have a place in a well diversified portfolio.

“We’ve probably had the best of them now although they’re still quite attractive – at least some sections (of the credit cycle) are,” he says.

Bamford says since March a lot of fund managers have been caught out by a sharp rally in the high yielding end of the corporate bond market, while everyone was focusing their attentions on investment grade debt.

“I think from an investment perspective now it’s quite important to have at least the flexibility for a fund manager to invest in both ends of the credit cycle – both investment and sub-investment grade.”

Bamford favours the M&G Strategic Corporate Bond fund, which he says continues to be attractive and incorporates the ability to invest a small proportion of the fund into higher yield corporate bonds.

While the hype around corporate bonds has died down somewhat since the end of last year/start of this year, investors still need to be wary not to get caught up in it, Bamford warns.