Spreads have fallen over the past year and compensation for credit risk has therefore reduced. How...
Spreads have fallen over the past year and compensation for credit risk has therefore reduced. However, we should firstly consider performance against other asset classes. Investment grade bonds have outperformed both gilts and equities.
The credit blow-out trend of the previous 18 months has not disappeared but provided investors avoided recent cases such as Ahold, British Energy and Avone Energy, they will have fared well in this environment.
So far this year, 10 of the 20 worst performers were BBB-rated compared with 15 of the top 20 performers so stock selection remains key to performance.
So why have investors been committing new money to this asset class? The higher yielding, lower rated bonds fared better, with the BBB index the best performing asset class with a total return of 7.39% compared with 1.18% for Gilts.
With government bond yields falling steadily over the year, apart from a short-lived after the Iraq war, investors have been eager to buy higher yielding names. This demand has mainly come from insurance companies reducing equity to maintain solvency levels and pension funds increasing bond exposure to match their liability profiles.
Other technical drivers of spreads include more corporate bond indexed funds with regular cashflows that need to be reinvested and the significance the derivatives market is having on the underlying credit markets.
While demand remains firm, the situation is further accentuated with a decline in supply of new corporate paper as corporate treasurers continue to focus on debt reduction despite the favourable combination of historically low absolute yields and tight spreads.
Credit fundamentals are showing signs of improvement and it has been some time since any significant negative credit events. Corporate results are not painting too disastrous a picture and more stable equity markets have taken the pension funds deficit story out of the spotlight.
Negative rating trends appear to have stabilised, with a recent report from Standard & Poor's showing while 2002 was a record year for credit defaults, it appears to have peaked in June.
The ratio of downgrades to upgrades was higher than in 2001 and 2002 experienced the biggest increase in the number of bonds falling out of the investment grade universe.
The agency states that, provided the economic recovery does not falter and there are no nasty credit surprises, the worst may be over, although the outlook remains extremely fragile.
It is interesting how the pattern of credit quality has changed with regard to new ratings as more lower quality corporates have sought ratings to access funding in the capital markets.
While on valuation grounds the investment grade, sterling denominated, corporate bond market looks expensive, there are some strong technical drivers behind this that are not going to disappear in the near term. The key will be whether we start to see improvements in underlying credit quality to support these valuations. Then it really will be 'off to the races'.
Strong demand for higher yielding paper.
Companies focusing on reducing debt.
Credit fundamentals starting to improve.
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