With corporate bonds outperforming government in eight of the last 10 years, the asset class has finally become an accepted part of the investment market
After twenty years as the poor relation of the investment markets, corporate bonds have finally come into their own. For the first time in the UK, the size of the corporate bond market (£247bn in issue) has outstripped government gilts.
Market forces ' regulatory change, slowing inflation, the reach for yield ' all favour corporate bonds. These trends are set to continue and nowadays any investment house worth its salt must have the capability to manage corporate bonds.
The foremost influence on investor demand has, of course, been the dramatic decline in world inflation. While equities have struggled with the consequences of disinflation (higher quality earnings but loss of pricing power and destruction of productive capital), fixed income markets have celebrated with an unprecedented squeeze on yields.
Although corporate bonds are dependent on company fortunes, investors retain some protection, even in extreme cases of insolvency or default. Well-managed portfolios of corporate bonds, with effective covenants and the appropriate sectoral split, have delivered high-quality returns in both the short and medium term.
This fundamental change in the fortunes of bondholders would, however, have been much less powerful if technical factors such as regulatory change had not pushed yields in the same direction. Over the past 10 years, pension funds, insurance companies and individual investors have either been gently encouraged or even forced to buy more corporate bonds.
The minimum funding requirement (MFR), tightening of tax and solvency regulations and the desire to encourage personal saving, have all played their part. The interaction of regulation and yield compression has had the compound effect of directing cashflow into this strongly performing and increasingly expensive asset but the party is not over yet.
The influence of FRS17 on Corporate Finance directors is likely to lead to the next stage in corporate bond outperformance and a further fall in yields.
This brings us to the third factor that influences asset performance: valuation. Over the past 10 years, as government bond yields (assumed to be risk-free) have fallen from more than 10% to less than 5%, the positive differential offered by corporate bonds has also fallen from a broad average of 2.5 % to about 1%.
Nevertheless, corporate bonds still represent good value. As inflation has fallen, from 10% to less than 3% over the same time period, the real relative and absolute value of bonds has been maintained.
In eight out of the past ten years, corporate bonds have outperformed government debt. So long as the yield premium continues, outperformance can be sustained.
There are some caveats. The market in corporate bonds, while growing strongly, shows no inclination to offer any increase in liquidity. The money lost by investment banks in the 1990s, seeking to build market share through market making, has brought most of them to their senses ' or to their knees.
The business model has changed. Encouraged by the regulatory penalties imposed on stock inventories, banks no longer devote capital to the secondary markets.
When events adversely affect particular bonds or sectors, the end investor is generally alone in bearing the short-term pain on the profit and loss account. While this has implications for tactical asset allocation, it should not be allowed to distract investors with a fundamental strategic reason for holding corporate bonds.
The education process now needs to be moved on, with investors benchmarking their portfolios ' and their fund managers' performance ' with a full appreciation of the risks and rewards.
As the more informed investor and pension fund trustee now understands, the biggest risk on a corporate bond portfolio is not default.
Default is rare and protection is readily available. Portfolio diversification, the active monitoring and management of individual credits, careful selection of bonds with effective covenants and, of course, the yield on the bonds themselves, all offer a defence against loss.
Covenants, the small print in the issue document, now offer the most familiar protection as the security of mortgage debentures has fallen out of fashion. They are designed to prevent corporate management from acting against the interests of bondholders.
There is real value in covenant protection but only if the situation triggers the specific clause. For example, investors in Evans of Leeds or Capital Shopping Centres would have needed very specific options, triggered by the company going private or limitations on issuance of more senior debt, to have gained any real benefit. Should investors have demanded protection from Allied Domecq selling off some of its key brands?
In recent years, a lot of faith has been placed in interest rate step-ups and step-downs, designed to dissuade issuers from various courses of action, most commonly anything that would trigger a negative credit rating review. While this clearly has some value applied to companies on large capex programmes, is it the correct course of action in all cases?
An alternative protection, whereby the assets of the company are securitised and thus, in theory, made safe from the predations of corporate management and takeover, remains unproven and dependent on the small print of the issue document. None of the above are as good as the real protection of thorough credit analysis and negotiating a higher yield up front.
Until the dynamics of capital markets change and management is rewarded for defending the interests of bondholders, rather than generating shareholder value, investors will always be best served by securing the appropriate yield.
There is, of course, a limit to the protection yield can offer. For most investors, the esoteric wastelands of junk bonds, distressed debt and faltering sovereign creditors such as Argentina are far from suitable. The key reason for holding bonds is to secure a reliable income. Any securities with a high probability of default should be regarded as equity-type investments, which may deliver superior returns but not on a risk-adjusted basis.
The reach for yield in a low inflation world can still be satisfied with investment grade issues and without taking undue risk.
Specifically, if economic fundamentals ' low inflation and steady growth ' remain benign and technical influences, regulatory and demographic, remain supportive, then the prospects for capital gain and further yield compression remain in place. While markets may suffer temporary setbacks and corporate bonds often struggle to sustain their outperformance in the second half of each calendar year, the next big thing to hit the markets is undoubtedly supportive.
FRS17, the next piece of legislation to land on the desks of pension fund trustees and company finance directors, will specifically incentivise them to match up any pension fund liabilities with high-grade (AA-rated) corporate bonds. There is, of course, no compulsion to do so and indeed little opportunity in the way of AA bond issuance.
Finance directors are perfectly at liberty to take more investment risk, in the expectation that long-term returns on equities will minimise the absolute cost of funding. They will, however, suffer the consequences of increased volatility of reported earnings as the regulations come into force.
It is surely much more likely that pension schemes will shift more of their assets into a selective combination of AAA and A-rated bonds? The impact of this reach for stability and yield will provide further support for sterling corporate bonds in the medium term.
Over the last 10 years, pension funds have been encouraged to buy more corporate bonds.
Defaults are rare in the corporate bond market and protection is readily available.
FRS17 will incentivise the matching up of pension fund liabilities with high-grade corporate bonds.