UK corporate bonds have had a tough time of late but opportunities exist and things are looking up, says Rupert Walker
It has become harder to create new bond portfolios to attract investors with the promise of high income yields. A year ago, investment houses competed with each other and rival equity products for intermediary attention and Isa money. Since then yields have fallen and spreads against UK gilt yields have narrowed for the type of credits bond funds would like to buy without raising the risk profile to a level that makes default probabilities unacceptable.
During the year to 12 April, two-year gilt yields fell 1.32%, five-year gilt yields fell 0.88%, 10-year gilt yields fell 0.32%, while long dated gilt yields simply stayed low. Credit and swap spreads fell even further. The spread over gilt yields of the UBS Warburg Sterling All Stock Index tightened 1.23% during the 12 months to 30 March.
Across yield curve segments, 1-5 years had total return for the quarter of +2.46%, 5-10 years +3.32%, 10-15 years +2.01% and 15+ years -0.33%. The short end of the credit curve clearly benefited from expectations of interest rate cuts by the MPC. The long end, although producing the highest excess returns over gilts (+1.94%), suffered from the yield curve steepening that is normal for the current phase of the interest rate cycle and will no longer be mitigated by the Minimum Funding Requirement since the Government's recommendation to abandon it.
The first quarter of this year has seen a continuation of this trend. The UBS Warburg Sterling All Stock Index, consisting of 719 bonds across six sectors and 25 sub-sectors, showed a 1.57% total return during the first quarter of the year, which was an excess return over UK gilts of 0.92%.
The best performing sub-sectors were manufacturing (+4.06%), healthcare (+3.49%) and basic materials (+2.91%), although financials (+2.54%) produced the highest return for broader sectors. Conversely, the weakest performers were water utilities (-1.35%), telecoms (-0.89%) and property (-0.66%).
Curiously, speculative (non-investment) grade credits gave the best total return (+2.54%) compared to 1.41% for AAA bonds and +2.23% for AA bonds. This was unexpected because anecdotal evidence suggests strong support for the two highest credit classifications from insurance companies addressing solvency problems and also a general move up the credit curve among investors worried about default risk for lower grade bonds.
The reason for this intuitively false relative performance is the coupon effect: most of the total return for the speculative grade bonds comes from income and not capital performance. The movement of yield premiums over gilt yields supports intuition. AAA bonds tightened by eight basis points, AA by 23 basis points, but speculative grade bond yields widened by 44 basis points.
More than 60% of the UBS Warburg Index is made-up of AAA or AA sovereigns. Issuers in this class have raised money through 'jumbo' deals to meet the demand from life insurance companies and pension funds that have been starved by the shrinking size of the gilt market and consequent reduction in yields available ' particularly at the long-dated end. The penalty of good husbandry in the Exchequer has been lower returns for funds that need to match assets to long-term liabilities
The other significant issuer group has been from the weaker end of the credit spectrum: telecommunication companies that have needed to raise large sums to fund 3G capital expenditure. British Telecom, France Telecom and Deutsche Telecom have all been major issuers of sterling denominated bonds ' but all at yield premiums over gilts far higher than before their spending bonanzas and the downgrading by the major credit rating agencies that inevitably followed.
Coupon step-ups and other punitive covenants have increasingly been attached to protect investors from further downgrades, creating further pressure on these companies to reduce their debt burden. Fortunately for them, the scarcity of high yielding assets with long-dated maturities has meant life insurance companies and pension funds have had an incentive to buy their bonds.
Against a still precarious environment for corporate credit, investors might need to accept lower yields unless they are prepared to shoulder the burden of price volatility, sporadic illiquidity, and heightened dangers of insolvency, which are inevitable consequences of moving down the credit curve. Arguably, a low inflation environment (2-2.5%), which the Monetary Policy Committee of the Bank of England has managed to sustain since its formation in 1997, means that investors can feel increasingly comfortable with historically low nominal yields. After all, it is the real interest rate they earn that really matters.
Nevertheless, there is much that bond portfolio managers can do to enhance returns, maintain income levels and assuage the worst aspects of risk. A well diversified fund is essential: diversified across industries, individual bond holdings and along the yield curve to protect against the sort of sharp twists in the curve seen since the death sentence was passed on the Minimum Funding Requirement.
There are still many opportunities in the sub-investment grade class to achieve capital gains through rating uplifts or companies becoming targets of better-quality predators. In addition, they can raise the overall income yield of the portfolio. Of course, many funds are prohibited from investing in anything below investment grade so the option is irrelevant.
But for funds where there is greater flexibility, one prudent method of portfolio construction is to ensure that the weighted average credit rating is at least investment grade. This can be achieved through a polarisation approach ' concentrating holdings at either end of the credit spectrum (AAA and B-), or else clustering around the middle so that the majority of bonds have a single A or BBB handle.
The temptation once a fund meets its diversification requirements, desired yield, duration, average life and credit rating average is to leave it alone. Excess trading should naturally be avoided, because although commissions are not paid for dealing in bonds, the bid-offer spread represents a hidden cost.
Although highly liquid issues from supranational agencies and sovereigns, for example, can trade on an eighth to a quarter point spread, the bid-offer spread on smaller corporate issues can be as wide as one percentage point ' and much wider for sub-investment grade in volatile markets.
Clearly, the danger of leaving a pristine model to achieve its targets is underperformance against benchmark indices and rival funds ' and far more seriously, the risk of neglecting constantly changing credit qualities, both real and perceived, of corporate bond issuers. A well-run fund should not over-trade, but through the diligence of applied credit analysis, it should make prudent, anticipatory and, when necessary, rapid reactive adjustments.
The corporate bond market will continue to be driven by imbalances caused by segmentation demands. In addition, major influences will be the performance of equity markets and their major determinant ' corporate earnings, and swap spreads, which are a major driver of primary issuance and hence guide secondary market yield spreads.
These are likely to narrow as interest rates continue to fall and the government yield curve steepens further.
Meanwhile, investors should be wary of funds that offer high yields as they also offer high risk. That is not a reason to avoid them, but it is a reason to be aware that there is a quid pro quo.
l A well diversified corporate bond fund is essential.
l There are still many opportunities in the sub-investment grade class.
l Excess trading should be avoided on bond funds.
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress