The ongoing volatility in the equity market and low inflation environment means investors are likely to continue to prefer corporate bonds to equities
There has undoubtedly been a shift in investors' risk profiles over the last three years, a period that has encompassed the bursting of the dot.com bubble, 11 September, a stuttering global economy, accounting scandals, the threat or war and unprecedented levels of corporate downgrades.
Against this turbulent background, it is little wonder a flight to quality has ensued and that government paper has been the main focus of investors' attention.
However, during times of risk aversion it is not unusual for investors to act irrationally. After a six-month period during which gilts have outperformed corporate bonds, average spreads on AAA and AA-rated bonds have widened only slightly, to 39 and 89 basis points respectively.
On the other hand, spreads on A and BBB-rated paper have widened much more aggressively and currently stand at 154 and 269 basis points respectively. For forward-looking, selective investors, these yield premia present an attractive investment opportunity, not least because the gulf that has opened up between A and BBB-rated stock and AAA and AA-rated stock is based as much on momentum as it is on fundamentals.
At current levels, the case for investing in corporate bonds has rarely been more compelling and a more favourable, or even neutral, corporate newsflow is probably all that it would take to revive investor interest.
The supply and demand argument is as strong as ever: low issuance coupled with strong and sustainable demand on the back of FRS17 and a growing realisation that both institutions and individuals should have more of their wealth invested in fixed income products provide significant grounds for optimism. Marks & Spencer and Granada have recently followed the lead of Boots in switching part of their pension fund assets from equities into bonds and it is highly unlikely that they will be the last of the blue chips to do so. Throw in low inflation, improved corporate governance and low and stable interest rates and the scene is perfectly set for investment grade corporate bonds. The crucial task for investment managers is to find the best way of capitalising on this potential.
The M&G Corporate Bond Fund is heavily overweight in BBB and A-rated bonds because we believe the relatively high yields on offer generously compensate investors for a only moderate increase in the risk of default. Spreads on A and BBB-rated bonds are currently discounting something of a Doomsday scenario that is unlikely to materialise. On the other hand, many AAA and AA-rated credits have become either fully valued or overpriced having piggy backed on the success of gilts over the last six months.
With little or no chance of being upgraded, the most highly rated corporate bonds offer unexciting returns. They are certainly the safe bet, and so far this year they have also been the smart bet, but it is unlikely this trend is sustainable.
Within the universe of stocks rated BBB by Standards and Poor's, tobacco groups Gallaher and Imperial Tobacco are good quality companies offering relatively high yields of 5.9% and 6.1% respectively. They are viewed cautiously by the major ratings agencies following cash acquisitions in Europe and Russia, which although making sense strategically, have increased each company's leverage. However, neither company is short of cash nor are they threatened by US litigation that has blighted the rest of the tobacco sector. Better still in the case of Gallaher, there is some speculation the company could be taken over by BAT, an AA rated tobacco company, which would be extremely positive for bondholders of Gallaher.
Whether or not this take over becomes a reality, the foreign operations of both Gallaher and Imperial Tobacco should benefit from synergies and any increase in margins is likely to be viewed favourably by the ratings agencies, possibly leading to an upgrade within two years.
By contrast, the next movement in the ratings of many UK insurance companies is much more likely to be down than up. Many retain AA ratings, despite concerns over solvency ratios owing to the poor recent performance of equities coupled with ambitious guarantees made when equity returns were significantly higher.
In today's operating environment, it is not too controversial a statement to suggest that the income streams of tobacco companies are more dependable than those of insurance companies.
There are many similar examples of pricing anomalies throughout the corporate bond universe where bonds issued by well-financed companies are available on generous terms. That said, there are also many companies whose debt is to be avoided.
Lessons have been learnt from the recent spate of corporate defaults (247 according to Moody's over the last 12 months), not least the importance of credit research. Nobody wants to be caught in possession of the next major casualty so thorough credit analysis and wide diversification are the obvious preventative steps for those with a sufficient resource.
It is not possible to do this using equity analysis. Many corporate bond issuers do not issue equity, besides which equity analysis and credit analysis are very different disciplines. Where equity analysts are looking for growth potential, the focus of credit analysts is on the sustainability of cash flows.
In a rapidly evolving and expanding market, independent credit analysis is likely to play an increasingly important role in corporate bond fund management.
While the major ratings agencies provide an important insight into the current financial strength of a company, our analysts are also looking to predict the future pricing of a companies debt.
Specifically we are aiming to identify those companies offering generous yields in relation to their long-term prospects and avoid those that are not.
It is this forward looking approach that has enabled us to identify recent corporate casualties such as British Energy, TXU and ABB in advance of them being downgraded by the ratings agencies.
In spite of a generally poor corporate newsflow, excluding property, corporate bonds have still been the best performing asset class over the last three years. Average annual returns of 9.0% (as measured by the Merrill Lynch Sterling Corporates All Stocks Index) are not to be sniffed at in any economic climate.
Advocates of the myth that all corporate bonds are merely quasi-equities might consider the performance of equities over the same period ' for the record the FTSE All-Share Index has fallen by an average of 11.0% per year.
The performance of investment grade corporate bonds is highly correlated to the gilt market. Within the asset class, A and BBB-rated bonds offer attractive yield increments for a limited increase in risk. This risk can be further reduced through diversification and thorough credit research.
Over the long term, BBB and A-rated corporate bonds have outperformed gilts as well as higher rated corporate bonds, a pattern that has only reversed over the last six months because investors have sought to protect their capital rather than grow it.
Inevitably however, investors will look to increase their wealth over the long term. In a low inflation environment supported by a favourable demand/supply imbalance, corporate bonds would seem the obvious choice for investors seeking diversification away from a troubled equity market.
Against a turbulent background, the ensuing flight to quality in the bond market has not been particularly surprising.
At current levels, the case for investing in corporate bonds has rarely been more compelling.
In a rapidly expanding market, independent credit analysis is likely to play an increasingly important role.
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