For a long time, corporate bonds have been seen as a safe-haven for investors seeking steady and relatively stable above-average returns.
And despite the odd disasters such as Enron and WorldCom, the sector has played its part pretty well. January IMA statistics show investors have faith in the bond sector, with inflows of £184m, despite retail sales as a whole falling £550.5m.
However, the sub-prime crisis and subsequent credit crunch have thrown up serious queries about corporate bonds, and many smart investors are beginning to evaluate their positions in these portfolios.
While corporate bond spreads are looking more attractive than at any time in recent history, the level of liquidity in the current market is virtually not existent. Financial institutions are avoiding corporate credit as they look to clean up balance sheets and the secondary bond market is being hit by the lack of buyers.
In a note to clients last week, Baillie Gifford Corporate Bond fund co-manager Stephen Rodger revealed January will go down as one of the worst months on record for the European high-yield market. While Rodger says nothing has “gone wrong” in his portfolio, he understands what impact investor outflows could have on the best funds in the sector.
"We’ve put together liquid portfolios in the context of the market. There are forced sellers out there and they quite often have to sell the better quality names because there is a market for these securities, while they cannot sell the illiquids. Eventually of course the illiquid names re-price," he says.
City Financial Strategic Gilt fund manager Ian Williams also questions the attractiveness of corporate bonds in the current climate.
“It’s pretty simple really, corporate bonds are not desirable to hold and significant outflows are a possibility and more likely a probability," he says.
"In fact, it’s not that hard to imagine these corporate bonds funds going the same way as commercial property last year and putting redemptions in place. I would say it would probably be easier selling an office block than getting rid of some of these bonds.”
Williams pointed to news in the US last week that Citigroup had to shut the doors on one of its hedge funds which specialises in corporate bonds, after 30% tried to get out of the $500m vehicle.
The liquidity problem highlights the importance of bond ratings, especially with expectations of a wave of downgrades circulating. Any widespread downgrade could seriously dent the majority of bond funds which are required to maintain at least AA paper. But Williams believes the problem is not in individual downgrades, but in the monolines.
The bond insurers, or monolines, allow potentially BBB rated bonds to be transformed into AAA for example, and they are currently coming under huge pressure to keep their wrapped ratings from being downgraded.
Williams says these once rock-steady monolines will struggle to keep ratings and investors need to look at other options if they “want to sleep at night”.
“I have never seen an environment like this, if one monoline goes (under) it forces your hand, and a fund could lose 20% of its value straight away,” Williams says.
“It is true the monoline problem is worse in the US, but the fear of these going under is real and the fear of investors losing money is going to hit inflows and redemptions are a serious possibility.
“There are a lot of smart IFAs out there but I would doubt whether the majority know the extent of the possible problem. For an adviser to do the job properly they would have to get their clients out, before everyone else.”
Hargreaves Lansdown senior fund analyst Meera Patel agrees there is a “monoline problem”, but she says any downgrade would not impact funds too heavily.
“Clearly there is a risk which has developed from the credit crunch and it is definitely more risky on the high yield side,” Patel says.
“While we would expect to see some defaults, there are some very good valuations out there.”
Patel says all bond funds have the ability to enter a redemption period, but she doesn’t expect any such occurrence.
“I have heard what bond managers are saying and they aren't getting too many grey hairs," she says. "As in everything I suppose, the key is to pick the right manager."
Standard Life Investments global thematic strategist Frances Hudson says while the credit crunch has seriously dented CDOs (Collateralised Debt Obligations) and forced five global SIVs (Structured Investment Vehicles) to fold, she expects corporate bonds excluding financials to hold up well.
"The warning signs have been here for some time," she says. "It has been possible to steer around many of these problems."
Hudson says investors may find interesting opportunities in the current market, especially considering spreads in Europe "imply a recession".
"Non-financials should be fine. Investors need to look at things on an issue by issue basis and there are a many decent companies out there," she says.
"If you have a healthy appetite to risk, there is value and opportunity in today's market. It's a little too late to panic."
While it is clear liquidity in the market has dried up and downgrades are a possibility, corporate bond funds are still going to be a major player as investors require fixed income exposure. Gilt funds will see a pick up in business but uncertainly over interest rates could affect this area as well. Cautious investors may not be willing to take on equity-type risk with the current bond market as the dangers particularly surrounding high yield names are real. Investors must take a good look at their portfolio and determine whether the risk is worth taking as long-term, forecasts remain optimistic.
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