Lower-rated credit attracts yield-hungry investors to corporate bonds

Corporate bond funds have enjoyed strong inflows as investors look for yield that is relatively defensive. While uncertainty over sovereign debt and global growth has reduced yields on top-rated sovereigns to an all-time low, it has boosted credits, whose interest-rate component has been powering returns in this asset class in 2011 and so far this year.

Higher grade A and AA corporate bonds are relatively safe but yield a paltry 3 per cent and would suffer if interest rates rise, while some financials could yet be downgraded. Many investors are instead turning to lower-rated credit to obtain uplift such as names exposed to the business cycle. High yield, which is paying 7.5 per cent, compares well with equities on a risk/return basis and is the most crowded trade.

The prevailing view among fund managers is that sentiment is overly downbeat, probably a result of the frustration over the sluggish rate of progress in Europe. Reported earnings are generally better than expected, including banks. Austerity programmes are being implemented and, although growth in global GDP has slowed, it remains intact. Corporate managements are proving better able to look after their balance sheets than politicians and, although there can be turbulence in the market, this often creates buying opportunities.

The crossover market – BBBs and BBs that could be upgraded – is a hotly favoured niche. Paying around 200 basis points over Treasuries, the crossover space also offers the opportunity for spreads to compress as interest rates rise, which is a given, sooner or later.

“BBs paying 5-5.5 per cent are a real advantage to the fund – the opportunity for price appreciation is a nice kicker,” says Bob Persons, fixed-income portfolio manager at MFS.

“Sixteen companies in the Meridian Research Bond’s index have been upgraded from junk to investment grade in the last two years, and they go up by 1.5-2 per cent on the day they are upgraded,” he explains. “Moreover the possibility of upgrades by the ratings agencies is not dwindling – there were four in the last quarter of last year and three in the first quarter of this year.”

LOWER CORRELATIONS

The Nordea US Corporate Bond Fund also allows investors up to 10 per cent participation in the crossover market. “This preference reflects not just our belief that corporate issuers will continue to perform well, but also that lower quality issues will exhibit lower correlation to US Treasuries in a rising interest rate environment than their higher rated counterparts,” says Dan Roberts, CIO at Nordea.

“We feel this part of the market will continue to offer the best source for risk-adjusted returns,” he adds. “As we move further into this economic cycle, individual security selection will become increasingly important from a risk control perspective. Understanding sources and uses of cash, the quality and vision of corporate management teams and the conditions influencing companies and industries will be important considerations for investors.”

Mr Roberts believes that the interest rate cycle is likely to play out in a range-bound fashion in the near-term. “But longer-term, the flood of liquidity into the markets by central banks across the globe could lead to a difficult renormalisation of interest rates that can negatively impact the returns on higher quality corporate bonds,” he explains.

CONTAINING CREDIT SPREADS

The deleveraging of banks as a result of Basle III and other initiatives has been attractive to bondholders, though not of course to equity holders. There is widespread confidence that the European Central Bank cannot leave banks out in the cold and its care should keep credit spreads from soaring.

“We like top tier and national champions, the top two or three banks in each country that are too big to fail,” says Alister Brown, product manager, fixed interest, at Invesco, who points out the marked improvement in banks’ capital ratios.

For example, in June 2007 Lloyds Bank had a 7.1 per cent capital ratio but by April it had risen to 11 per cent. Swiss Bank UBS had a ratio of 10.8 per cent in 2Q 2007 and this had risen to nearly 20 per cent by Dec 2011. Even many Spanish and Italian banks have hiked their ratios to over 10 per cent, says Mr Brown.

Another possible consequence of the financial sector’s Herculean efforts to reduce balance-sheet risk is lower profit margins and a shake out in the market, leaving survivors with solid operating structures and lower earnings volatility, says Frederic Salmon, senior investment manager, fixed income, at Pictet Asset Management. “This is where we primarily situate potential for returns in the months ahead.”

A contraction in the supply of paper is also driving the market. Non-financial firms are applying the brakes to investment spending and are hesitating to gear up again as the outlook is opaque. The apparent steady growth in new issuance has largely been companies taking advantage of the low interest rate environment to term out their high interest cost debt, in effect refinancing activity, while net supply has declined. Meanwhile banks are benefiting from central-bank funds and boosting their efforts to gather deposits.

“Regarding this supply-demand mismatch, the risk of paper shortage — if conditions clear up — has rarely been so high,” adds Mr Salmon. “This is a very positive factor.”

EMERGING MARKETS

Managers continue to boost their exposure to emerging market debt, which is now a trillion dollar asset class paying a material spread and likely to benefit from currencies appreciating at 2-3 per cent pa over the medium term. As far as security goes, default levels are lower than in the developed world.

“In fact there are so few defaults that although optically they look better, there are still questions around creditor protection,” says Steve Cook, managing director at PineBridge Investments.

“Up to 75 per cent of emerging market corporate debt is investment grade and, significantly, the majority of high yield names in emerging markets are smaller than their US counterparts. That has to be good because their leverage is less, reducing the risk of default, and additionally they have higher margins as lower cost producers generally have better profitability,” explains Mr Cook.

“However, a key weakness in emerging market high yield in comparison with the US is that you know what the recovery rates will be in the case of a US default. In emerging markets it is less clear – there are 38 different countries represented in our funds, and although bankruptcy laws have improved, they all have different regimes.”

Elsewhere there are specialist areas which are attractively priced because they have burned investors previously, such as the non-agency mortgage market and the asset-backed market in the US.

“Many of these individual securities backed by bad risk borrowers have been rated triple C by the agencies but you can pick them up at very attractive levels because they are unloved, have a low rating and are hard to analyse,” says James Mitchell, portfolio manager, at Russell Investments.

“Specialists in this area in the US, such as Brookfield and Smith Breeden, will analyse the mortgages in the pool and apply stress tests to see what the bonds are worth.”

Room for both boutiques and major players

The direct purchase of bonds becomes feasible for portfolios of £3m (E3.75m) or more, but many investors will prefer to use funds for diversification. The corporate bond fund space is split between the giants, such as those houses in our table, and the boutiques, whose scale allows them to identify companies they like and take meaningful position sizes relative to the portfolio without having to take a large absolute position of issue.

“Some large managers have a more top-down approach, but if you want a bottom-up approach a boutique is usually better,” says James Mitchell, portfolio manager, at Russell Investments.

“If a manager has a large asset base and they tell you that their key focus is on relative value between names, then you probably will want to question that. But there is still scope for the big guys to make top-down macro calls. If market sentiment changes rapidly, as it did in the third quarter of last year, when it became very risk-off, then it is much tougher to get out of existing positions, which can then lead to a choppy ride with the big players. However, both styles can work well and we try to blend them in our multi manager funds.”

Wealth managers have been warning about the need to approach liquidity with care, arguing that when returns are low, the risk is fund managers will be encouraged to accept poorer quality and less liquid assets to boost payoff.

Coutts takes a very different stance from its peers in relation to ultra long duration. “Valuations are attractive and we believe there will be a multi-year period of deleveraging with no monetary policy-induced bear market in bonds,” says Alan Higgins, CIO UK. “We have a strong macro view that there will not be any material increases in rates for five years, except perhaps for a token half or quarter per cent but even that, not for 12 months. Pension funds have also pushed up pricing and created a good steady source of demand.”

Consequently Coutts recommends long duration funds such as those run by Fidelity, Insight and Pimco, in addition to M&G and Invesco Perpetual at the short end of the curve.

Investment-grade corporate credit spreads are almost certainly overstating future default rates, so there are strong arguments to use derivative products that access the spread such as Credit Default Swaps. The iTraxx index for European investment grade credit, at 157 basis points, implies a five-year cumulative default rate of 13 per cent, at a time when companies are cash-rich, compared with the worst historical five-year cumulative default rate since 1970 of 2.4 per cent, says Duncan Sankey, head of research at the London hedge fund, Cheyne Capital.

“The market is pricing in armageddon although companies are profitable,” he says. “They have been reducing their leverage and are now sitting on tons of cash.”

VIEW FROM MORNINGSTAR

The impact of the financial sector

Euro Corporate bonds posted solid returns over the past 12 months, with the Morningstar EUR Corporate Bond category average returning 4.48 per cent during the period April 2011 to April 2012. Yet it’s been a rough ride for investors, as the credit market suffered from repercussions of the European debt crisis last year, before benefitting from a more positive outlook as macroeconomic conditions improved in the first quarter of 2012.

The financial sector weighed significantly on the category’s overall performance, both on the downside and during the rebound. In particular, funds with significant exposure to banking and insurance debt struggled in 2011. Although these funds were able to compensate for some of their losses in the first few months of this year, many still lagged behind their peers over the 12 months up to the end of April.

For example, MS INVF Euro Corporate Bond returned 3.4 per cent over the period. The team’s positive outlook for credit led to an increased exposure to Lower Tier II bonds. This overweight on less senior bonds and lower credit quality issuers was also reflected by the portfolio’s average credit rating of BBB.

Another fund which held on to its offensive positioning on financials in spite of the crisis is Invesco Euro Corporate Bond. The fund is managed by Paul Read and Paul Causer, and throughout 2011, the managers broadly emphasised higher-quality banks but also invested in subordinated instruments where they believed spreads to be unjustified by fundamental factors. Although the fund struggled massively in 2011, its strategy paid off during the first few months of this year, and was 284 bps ahead of its peers at the end of April.

Mara Dobrescu, fund analyst, Morningstar, Inc