This week’s Conjecture panel debates whether current yields are bringing enough reward for the risks take and what issues managers in the sectors are currently facing
IMA Sterling Corporate Bond has been the best-selling sector among retail investors every month this year. But corporate bonds are not without volatility either. Are current yields sufficient to reward for risks and what issues are managers focusing on?
This week’s Conjecture panel consisted of Bryn Jones, manager of the Rathbone Ethical Bond fund and Adam Mossakowski, who runs the Strategic Bond and Extra Income Bond funds at F&C with Fatima Lewis. The two F&C funds sit in the IMA Strategic Bond sector.
Which areas of the corporate bond world are no longer as cheap as a few months ago? And have some sectors now moved towards fair value?
Bryn Jones (BJ): There has been a big rally in the corporate bond space in the last six or seven months. We saw the bottom, in terms of prices, around the end of February. Since then, we have seen the corporate bond market, excluding financials, rally quite aggressively.
The yield on these corporate bonds, is now actually below the yield of pre credit crunch, despite the fact spreads might be a little bit wider, because of the underlying impact of gilt yield falls we have seen. Some of these bonds look rather expensive now.
We still think there is a lot of value in some of the financials, so, if anything, when looking at just the corporate bond space, there is a lot of value in financials, but some of the more short-dated pure corporates are looking a little bit expensive.
Adam Mossakowski (AM): If you look at more utility-like sectors – telcos in particular – something like long-dated Vodafone paper is back on the spread basis and back to mid-2007 levels. That is not just pre-crisis, that is before US sub prime blew up. I think that says a lot about the flight to quality we are seeing. Even within corporate bonds, like Bryn said, financials are still cheap but the net result is other areas get squeezed – so there are some pockets of expensive bonds.
Have you been surprised by the performance of the corporate bond market?
AM: Yes. To come back from such wide valuations to trading levels similar to 2007, has caught quite a few people by surprise. But it has been a very sector-driven correction, financials are still cheap, securitised and ABS bonds still trade at cheap or even sometimes distressed levels. There has not been a uniform correction by any means.
BJ: I have been slightly less surprised. Thinking about it from an anecdotal point of view and looking back through history, if you look at all other credit spread-widening events, they are normally followed, quite sharply, by a strong rally in credit. In February and March of this year, as a result, we felt bonds were oversold and, in particular in the Ethical Bond fund, we were out buying Tier 1 debt and subordinated insurance because we felt the performance of the market following a year of significant declines is normally quite good.
What I am more surprised about is the demand for credit, which is continuing at the moment. If you look at a lot of the new issue space, the demand is exceptional. We had the Credit Agricole deal which was 10 times oversubscribed in euros. There is still a huge amount of money piling into the corporate bond space and that is what I am more surprised about – the level of cash still coming in.
Do you think demand will continue to increase?
BJ: The demand is going to continue while we have this philosophy of low rates for longer – central banks keeping rates at very low levels for longer periods of time.
There are small pockets of rhetoric appearing from some of the central banks and we are going to need to consider exit strategies from the very easy monetary policy we have at the moment.
But, while we have these low rates and people are earning very little in cash, we will continue to see the demand into what is a much higher significant yield than they are getting out of cash.
At some point, quantitative easing will be stopped and indeed reversed. What will the impact of this be on the corporate bond market?
AM: We know that quantitative easing in the UK will formally stop in November, as that is when the current remit runs out. I guess there are two questions. One, will they extend the QE programme and two, how and when will they unwind it?
I think the first question is tricky. I think they would want any extension to QE to be a surprise as if the market knew about it, it wouldn’t have the effect it was supposed to.
With regard to reversing, I think they are a bit stuck. It is difficult to flood the market back with all those bonds, they could be holding them for a very long time.
We have seen that in Israel where they had a QE programme that has been stopped.
BJ: Quantitative easing is an argument we have recently written about and done some press releases on. It is our big concern because the gilt market will come under a lot of pressure if it is flooded.
You have rating agencies looking at the credit quality of the UK government and if they do not sort out their fiscal position, rating agencies could take a dim view of that.
If the market does get flooded with gilts, with extra supply coming to the market because of the lower tax take, it will be an awfully messy situation.
However, I think there is a potential side door for the Bank of England. Under the current remit, they may well be forcing all the commercial banks to be holding gilts. One of the big issues was that the credit quality of their asset books, of their treasury books, was not particularly good in the past. So there may be a situation where they will force the banks to hold 10% in gilts.
I have seen some figures already and they reckon £120bn of gilts could be bought by the commercial banks. That would certainly go some way to sorting out some of the mess. I think it is potentially, other than the issue of holding them to maturity, one of the only ways out for them.
Bond managers seem to be positioning themselves in one of two opposing camps, either a return to inflation or a period of Japanese-style deflation. As these outcomes offer very different prospects for fixed interest investors, are there any areas in the bond universe that can still provide steady consistent returns and lower volatility than equities?
BJ: If you do not know there is going to be inflation, or do not know if there is going to be Japanese style deflation, you may wonder what kind of investment you could make to actually protect from both sides?
In fact, medium- to short-dated inflation linked bonds are actually a very good idea. Because if you get high inflation you get inflation protection, so your coupon and principal goes up by that.
If you go through a period of deflation, you are in a very short-dated asset class, which is going to perform better than every other risk asset. Okay, you might lose 3% but if we go through a Japanese-style deflation for the next 10 years, you might find the equity market off 50%.
If you are going to think of one investment you can make if you do not know which extreme we are going to go through, then linkers are very good as another diversifier for the risk structure of your overall portfolio.
If you thought there is going to be one significant threat in the marketplace, what would that threat be?
BJ: It is going to be a left field event and it would be geo-political risk. We have not seen much of that of late. What happened in 9/11 was obviously disastrous, but clearly we have a huge secular change going on. Economies are moving up to the East and we are seeing a strong China. I think that is the thing that would concern markets – perhaps the impact of China not buying dollars and issuing more debt in their own currency. I think secular change and any geo-political risk that comes with it is a key risk that does not really get priced into markets.
AM: I would pick out China. It is a paradox. It needs to grow as quickly as it has done over the last 15 years for the next 15. And that is just to provide jobs to all those Chinese people that need them, and that is simply quite unsustainable going forward.
If we, in corporate bond world, were paid a premium to be invested in emerging markets to take that risk, then fine. But certainly when we look at emerging markets on a ratings for ratings basis, you are not really paid very much more to be in an Asian corporate than would be in its equivalent European or Western counterpart.
