While investors should be wary of the market's ability to absorb future outflows, certain funds remain worthy of strong consideration. City Financial's Anthony McDonald explains.
At the end of 2013, corporate bonds offered a distribution yield of 3.6%, using the Vanguard UK Investment Grade Bond index fund as a proxy for the asset class.
This historically low yield level is, of course, the result of the rock-bottom interest rates that have now been in place for over five years. With limited returns available from cash and, subsequently, government bonds, the gradual healing of the economy and strong investment demand have allowed corporate bonds to enjoy a strong rally since the start of 2009.
The asset class has delivered strong absolute performance of almost 8% per year and comfortably outperformed government bonds. However, when we speak to fund managers, they warn it will be difficult to sustain this level of performance, even simply mathematically, from such a lower starting yield.
Liquidity: The elephant in the room for corporate bonds
Investors should, therefore, be prepared to expect more sedate returns from their corporate bond allocations, driven primarily by income rather than outsized capital gains; a dynamic that already started to assert itself in 2013.
Nevertheless, within the context of modified expectations that incorporate a diminished risk/reward calculation, the majority of corporate bond fund managers that we meet remain positive on the sector.
This is evident through widespread underweight positions in the highest quality, AAA-rated part of the universe, albeit to a notably lesser degree than earlier in the recovery phase.
Within credit, a positive outlook is underpinned by the fact defaults are contained and they are likely to remain so, as many companies have limited refinancing needs.
Developed market government bond yields, against which corporate bonds price, may trend higher but are unlikely to sell off dramatically, as inflation and interest rates appear contained.
Indeed, central bankers appear at pains to draw back from their earlier forward guidance, as falling unemployment rates threaten to confuse their policy outlook and, while this is a potential credibility concern, it is unlikely to be an immediate threat to corporate bonds.
Apart from the likelihood of bouts of weakness in response to fluctuating economic data and interest rate expectations, perhaps the main short-term risk to the market is, in fact, related to the maturity of the credit cycle.
Indeed, we are seeing early indications that the abundance of cheap financing is encouraging companies to increase leverage gradually and any acceleration in this trend would place pressure on parts of the investment grade market. In this vein, the spectre of M&A activity already hangs over the telecoms sector and may help explain its shorter-term underperformance.
Despite broadly positive sentiment, selectivity is increasingly evident. Even those fund managers retaining a positive view on corporate bonds acknowledge that large parts of the market have rallied significantly, to the point where they offer less compelling value than previously.
However, the more subordinated parts of the market, namely old fashioned Tier 1 and Lower Tier 2 financial bonds and corporate hybrid paper (especially utilities), are available at a higher yield than the market average and are an important part of many portfolios.
Although the extra yield available, while still lending to higher quality companies, is attractive to investors with a positive general outlook for corporate bonds, it reflects the extra risk ascribed to subordinated bonds. We expect them to exhibit volatility in a market that remains dominated by macroeconomic and monetary policy uncertainties. We are, therefore, monitoring closely the extent to which different funds are invested in these parts of the market.
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