Although equities have received a great deal of attention in recent weeks, as investors start to look towards more riskier asset classes, the credit market could offer an even better investment
During the recent crisis, investors fled for the safety of prime money-market funds and developed government bond markets.
However, with money-market investments now generating meagre returns, cash is gradually being redeployed in riskier assets. Some institutional investors are considering shifting their allocations to equities to re-attain the equity exposure they would normally target (that exposure having declined because of the drop in equity valuations).
However, corporate debt currently offers a compelling investment opportunity, even compared to stocks, once relative risks are considered. Although corporate debt has staged a significant recovery in recent months, there is still ample room for improvement.
As risk appetite returns, many investors are rebalancing their portfolios, shifting cash and fixed income allocations to equities. If ‘fixed income’ meant only government bonds, that rebalancing would be attractive given the low yields and expensive valuations reached by the asset class in late 2008.
However, corporate bonds and other non-government bond sectors are major components of the fixed income universe, and the very attractive yields available there put rebalancing in a different light. Most of these sectors have reached valuations that offer an attractive investment opportunity to investors.
Investors may not realise that corporate bonds fell much more sharply than equities in the recent crisis, relative to historical norms. As valuations reached their lows, stocks were priced for an extended recession, while corporate bonds were priced for something worse than the Great Depression.
Looking at the relative attractiveness of these asset classes in terms of prospective returns implied by market prices, analysis suggests that the additional expected return offered by equities compared to investment-grade corporate bonds (equity premium) shrunk over the crisis and in fact fell to the lowest levels recorded at any time since the Second World War.
Over the past 45 years, equity returns exceeded those on investment-grade corporate bonds by approximately 2% per year. If anything, the relative valuations reached in late 2008 and early 2009 suggest that the equity premium is likely to be smaller in the years to come.
Although equities are likely to generate superior returns compared to investment-grade corporate bonds over the long run, investors should not forget that this has historically been achieved at a ‘cost’ of an additional 10%-20% per year of volatility compared to investment-grade corporate bonds. Indeed, corporate bonds offer attractive returns, as well as a prior claim on corporate assets, a historical risk profile far tamer than that of stocks and, for defined-benefit pension plans, more compatibility with strategic investment goals.
Corporate bonds also appear to bear less additional downside risk should an adverse economic environment continue, thanks to their senior credit position and more strained valuations.
Opportunities across bond universe
Although these arguments set out the case for investment-grade corporate bonds versus equities, the fixed income universe also offers asset classes with higher prospective returns than investment-grade corporate bonds for investors who are willing to take on more risk.
Indeed, high-yield corporate bonds reached similarly extreme valuations over the crisis and provide an attractive investment opportunity, even when allowing for historically high levels of defaults in those sectors.
Investors looking to shift allocations out of cash and government bonds into riskier assets have already missed out on a significant recovery in recent months. Within fixed income markets, the high-yield corporate sector initially led the recovery, but investment-grade corporate bonds soon followed. Both sectors staged record monthly returns in April and followed this up with another strong performance in May. Despite the recent gains, however, most non-government sectors still have ample room for improvement and are likely to outperform government bonds over the remainder of 2009 and possibly beyond.
Pricing in non-government bond markets was expected to converge towards fundamental values at a slower pace but market prices are quickly rising towards more accurate valuations. The investment case for credit is based on a number of reasons.
First and foremost, the dramatic increase in spreads over government bonds was driven by investors mispricing credit risk. In simpler terms, investors became too pessimistic about the outlook for corporate defaults and, more generally, the outlook for the economy as a whole.
As spreads peaked following the Lehman failure, corporate bonds were priced for an economic outcome worse than the Great Depression and investors expected more than 30% of all investment-grade companies and around 80% of high-yield companies to fail over the next five years.
While the liquidity issues surrounding financial companies have grabbed the headlines, corporate balance sheets of non-financial companies are in fact in better shape than in the 2001 recession. In addition, the policy action implemented by central banks and governments around the globe is unprecedented in both size and scale, and is at least partially aimed at restoring the functioning of credit markets.
These fundamental factors point to the default expectations discounted by markets being excessive and market developments over recent months suggest that policy action is now gaining traction and that market pricing is moving more towards what are fundamental values.
Although investors’ reassessment of the fundamental credit risk is likely to be the key driver of a continued improvement in credit markets, supply and demand factors are also supportive of the market. New issue supply is expected to be much lower than in previous years, while demand for credit may be boosted by a shift in allocation into the asset class from pension funds.
The riskier segments of the bond market provide investors with significant investment opportunities, especially for those who are reluctant to take on the volatility of equity market returns. With cash earning next to nothing at the moment, credit markets could be a first step into riskier assets.
Mike Zelouf, head of international business, Western Asset Management (affiliate of Legg Mason)
