Managers say low return on cash and search for yield will support fixed income market
Unanimously, the UK fixed income managers we have interviewed think in 2010 the search for yield will continue to support corporate bonds, given the very low returns on cash.
None of the managers expect credit spreads to widen in the coming months. The team at M&G sees a renewed bout of investor risk aversion as the main risk to the asset class.
In line with others, the team at Invesco Perpetual expects yield-based returns for 2010. They believe there is a good chance spreads will tighten modestly from current levels. Credit metrics should improve as the economy grows again, earnings improve and leverage declines.
The managers agree credit security selection will be crucial in 2010. M&G believes credit picking will be particularly important for the high yield sector. Andrew Sutherland at Standard Life Investments thinks cash-generating high-yield companies will continue to do well, despite increasing new issuance.
Many managers, among them Richard Hodges at Legal & General, are concerned about the increasing interest rate risk of many investment grade corporate bonds. Hodges has sold some high-quality paper (typically rated A or higher) because the issues have become more sensitive to interest rates than credit spread compression.
Most potential is seen in subordinated financials. Many managers prefer lower tier two debt from a risk-reward perspective. Fund managers are very selective when buying tier one paper, evaluating debt covenants (step-up coupons, for example) and the probability of the issue being called at the first call date. Many have rotated from older tier one into newer, more attractive tier one issues.
Fund managers agree the longer-term capital structure framework for financial institutions looks uncertain, but none was concerned about the immediate future. They all expect a grandfathering period to protect existing investors should capital structure changes be implemented.
Opinions were divided with respect to enhanced capital notes from Lloyds, contingent capital that would be converted into shares should the tier one capital ratio fall below a certain level.
Some managers have participated in the exchange offer on the basis that the conversion is a reasonably remote risk with adequate compensation.
Old Mutual’s Stephen Snowden notes asset-backed securities (ABS) have been gaining more sponsorship. He sees good value in senior ABS as many investors are underweight. He believes many investors are overweight defensive sectors and expects them to rebalance portfolios towards bank debt issues in particular. He generally expects a benign economic environment and a recovery in the job market.
Uncertainty remains around the Bank of England’s quantitative easing (QE). The Monetary Policy Committee kept the size of the asset purchase programme unchanged at £200bn at the February 2010 meeting. However, it signalled the potential for further QE if necessary.
The team at Invesco Perpetual echoed the consensus view: they do not foresee a big sell off when QE is exited but expect upward pressure on government bond yields as one big buyer leaves the market. The majority of managers run portfolios with a lower duration to mitigate this risk, although Andrew Sutherland saw performance potential in government bonds as yields have retraced to higher levels, particularly if equity investors get more nervous.
L&G’s Richard Hodges sees a double dip in the second half of 2010 as the biggest risk. He also identifies deflation as a potential tail risk event. To hedge against these risks, he has bought CDS protection in iTraxx Europe. However, the L&G Dynamic Bond Trust is also positioned to benefit from a continued rally in risk assets.
Team changes
Alasdair MacLean left Standard Life Investments (SLI) at the end of November 2009. SLI’s head of credit, Andrew Sutherland, took over MacLean’s funds, the Standard Life Investment Funds – Select Income Fund and the UK Ethical Corporate Bond Fund. We have awarded the two funds an S&P A/V3 rating following the change. Scottish Widows Investment Partnership (Swip) has continued to fill-in head count following the departure of four senior investment professionals in August 2009, and hired Roger Webb, Andrew Tunks, James Taylor and Mark Connolly in the past three months. Roger Webb, previously head of credit at Aviva Investors, strengthened Swip’s corporate bond capabilities. The Swip Corporate Bond Plus Fund is currently Under Review but we will re-interview the team shortly.
Markus Graf is a fund analyst at S&P Fund Services
