Despite poor sentiment, all the long-term factors supporting the case for corporate bonds remain in place, namely modest economic growth, low inflation and low interest rates coupled with strong secular demand and healthy supply
We have seen a lot of headlines about defaults, fallen angels, negative credit migration and so on over the last few months.
In reality, the corporate bond market continues to produce widely divergent returns, between credit rating categories, industrial sectors and individual bonds. Just like in the equity market, the recent shakeout has revealed some interesting valuations in a number of areas. And just like in the equity market, not all of them represent good investment opportunities. The ability to sort the wheat from the chaff now will add real value in the future.
It is important to note that despite very poor sentiment, the economic backdrop remains generally constructive for corporate bond issuers. The major economies are delivering modest growth and inflation and interest rates look likely to remain at historically low levels.
Having maintained a very defensive stance over the last six months, we have recently started to reduce the size of this position, principally via tentative additions in the investment grade telecoms and insurance sectors. Both of these moves echo the sentiments and actions of our equity team, with whom we liaise closely. We think that this close liaison between bond and equity managers is vital.
In telecoms, we have seen an improvement in news flow, particularly from the European operators. Deutsche Telekom has changed its management and strategy, while Telefonica announced its withdrawal from the heavily loss-making third-generation mobile market.
These pieces of news exemplify a new focus on capital constraint within the sector, which has hitherto been one of the worst culprits of capital excess. Moreover, our equity research has revealed that the European sector is now net cash generative for the first time in several years.
With the sector's bonds having reached oversold levels, we have added to our holding in Deutsche Telekom and also participated in an attractively priced new AA-rated issue in Australian operator Telstra. Our overall position is now broadly neutral relative to the competition, with a general focus on lower risk names. Our move to neutral proved timely, with the sector starting to outperform in recent weeks.
In insurance, we have been extremely underweight for some time because of concerns over equity exposure and solvency. This stance has served us very well as the sector has underperformed sharply. However, the period of underperformance has now revealed some good long-term value, and we have started to add very tentatively via long-dated holdings in Prudential and Legal & General. However, we remain significantly underweight and very selective in our holdings.
These moves have been funded via a reduction in our gilt holdings. Elsewhere, the previous positions remain broadly unchanged. We remain overweight in supranationals (European Investment Bank, International Bank of Reconstruction and Development), overweight in industrials (via less cyclical and less capital-intensive areas such as retail and tobacco), underweight in financials (both banks and insurers) and neutral in utilities.
There has been one new purchase in this last sector, namely a new BBB-rated securitisation from Anglian Water. This company offers stable cashflows and a transparent business model in a highly regulated industry.
That's enough of the present, what about the future? One thing we firmly believe is that the easy money has been made from sector and credit rating selection. In other words, stock selection will become increasingly important in the coming months and years.
We have had a good track record in identifying potential upgrades and avoiding most of the downgrades. Alcatel, Fiat, Ericsson, Tyco and Abbey National have all sold off on stock-specific issues, and none of them were held in our funds when their problems struck. By devoting additional resource to fund management and credit research, we are confident that we will be able to continue this record.
Higher inflation is bad news for gilts and higher-grade corporate bonds. Let us look at the risks to inflation and firstly the risk that inflation may rise. There is not much sign of inflation rising at the moment, but the risk is credible in the medium term for three main reasons. First, Central Banks are tending to give more priority to growth by keeping short-term rates low. This is especially the case in the US and to some extent the UK, despite a booming housing market. The concern here is that they keep rates too low for an extended period and eventually let the inflation genie out of the lamp.
Second, governments are relaxing fiscal policy. Again this is especially relevant in the US and the UK, but even in Europe the so-called stability pacts are likely to be broken with deficits rising above 3% of GDP. The concern with these rising public sector debts is that public sector pay and utility costs may start to rise, sparking inflation.
Finally, there may be military conflict in the Middle East leading to higher oil prices, which may feed into higher inflation.
Although these risks are real, the lags involved are likely to be substantial. We only have to look at Japan, where deflation rules despite 0% interest rules and an explosion in public sector debt. The flipside to higher inflation is of course that the current trend of falling inflation may develop into outright deflation (falling prices) with all the deferred consumption and economic stagnation that it implies.
What are the likely drivers to this potential threat? First, Anglo Saxon consumers could (some people would argue should) save more. Clearly, if this were to happen now, especially in the US, the main driver of growth would disappear.
Second, companies remain cautions and continue to cut back investment. This is a real threat, and we certainly aren't seeing many signs of increased corporate investment in the companies we speak to. Finally, higher oil prices might raise inflation in the short term, it would also reduce spending power and profits (except for the oil exploration stocks), and more likely result in lower inflation in the medium term.
Our house view is that inflation will stay low, but that deflation will not be an issue in the western world. The major western economies are structurally far more efficient than Japan's and policymakers have more tools at their disposal. The US Federal Reserve, for example, is well ahead of where the Bank of Japan was in the early 1990s, in terms of both monetary and fiscal easing. Moreover, although interest rates are low, western central banks do have scope to cut rates further if required.
So all of the long-term factors supporting the case for investing in corporate bonds ' modest growth, low inflation and low interest rates, coupled with strong secular demand and healthy supply ' remain in place. What is the right mix of bonds for the current market conditions?
Our research has shown that a 60:40 split between investment grade and high yield is a reasonable neutral position, delivering enhanced yield with lower volatility arising from the low correlation between the two classes of bond. Moreover, if inflation did rise, the high yield portion should benefit, offsetting any negative effect on the higher rated investment grade issues.
Managing a fund across the two classes of bonds has added real value but is a time-consuming business, encompassing a range of skills from the pseudo-gilt end right the way down to the higher risk issues in the lower rating categories. The key to performance from here will be identifying the best of the new and existing issues, and in this regard there is no magic formula: hard work and resources are the key.
We are confident that our strengthened team, together with ongoing co-operation between our bond, equity and property desks, will help us to continue to pick the right holdings.
Despite very poor sentiment, the economic background remains constructive for corporate bond issues.
High inflation is bad news for gilts and higher grade corporate bonds.
Deflation should not be an issue, as the major western economies are sound and policymakers have more tools at their disposal.
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