By Anna Lees-Jones, manager of the M&G Corporate Bond Fund Credit spreads have held up well amid...
By Anna Lees-Jones, manager of the M&G Corporate Bond Fund
Credit spreads have held up well amid the recent turmoil in equities. We see this as growing evidence of a decoupling of credit from equities ' with credit outperforming.
Increasingly more market participants seem to be remarking on this emerging trend and, although it may be partly because of strong technicals in the credit market, many of the recent 'winners' have been lower-quality, more distressed names such as telecoms operators.
The current environment of modest growth provides the perfect foundation for credit. There is enough momentum to prevent a fall into recession, but not so much as to divert management attention away from balance sheet repair and back towards re-leveraging.
It would be premature to get too carried away with such a nascent trend, but if other company managements follow the responsible lead now being adopted by telecoms operators the credit markets might be forgiven for getting excited.
Typically, over the longer term, returns from corporate bonds rank somewhere in between those of equities and government bonds. Government bonds have been well supported over the past two years, thanks largely to weak economic data and heightened geopolitical tensions. But with real yields now testing historic lows at sub-2%, further strength in government bonds is unlikely.
As for the outlook for equities, market participants are forecasting anything from a fourth successive year of negative returns, to a strong market rally. Somewhere in between is probably most likely.
We would not rule out a modest improvement in equities from current levels, but three successive years of negative returns have taken their toll and investors who have had their fingers burnt by being over-exposed to the asset class are unlikely to forget the pain overnight.
This brings us back to credit. It may be that we have reached the stage in the business cycle where corporate bonds become the asset class of choice. Certainly, the supply and demand technicals are stacking up nicely. In the UK, there is a huge pipeline of demand from both institutions and individual investors who are recognising the need to hold a greater proportion of their assets in bonds.
Bonds are the obvious choice for pension funds seeking to match their liabilities, insurance firms looking to improve solvency ratios and an ageing UK populous looking to secure superior levels of income in retirement. Marry this with low levels of supply, stemming from companies' new-found willingness to deleverage, and the credit quality enhancements that go with this, and the buy case for corporate bonds is beginning to look like the archetypal 'no brainer'.
Of course, there is no such thing as a free lunch and, as with any investment, there are associated risks. Many corporate bonds are overpriced. This includes those at the upper end of the credit curve that have benefited from a momentous flight to safety over the past 12 months, and those lower down that are trading at distressed levels because they deserve to be.
Investors should identify companies that are demonstrating a willingness to cut costs, disposing of assets or restructuring. Ultimately, these companies will be best equipped to improve their margins and, with it, their credit profiles. There are many such examples among A- and BBB-rated companies, but credit research and careful stock selection has rarely been more important.
Modest growth perfect for credit.
Balance sheet repair underway.
Strong supply/demand technicals.
Focus may switch to re-leveraging.
Distressed companies can get worse.
Economic uncertainties are persisting.
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