As global markets slowly recover from the their recent lows, corporate bonds are likely to outperform, just as they did following the recession of the early1990s
History has a knack of repeating itself ' or so they say. Over the past few months, the financial press has been filled with a raft of stories quoting previous market downturns and the events that followed.
It is obviously a dangerous game to suppose that what occurred before will automatically do so again. Yet history can be our friend for no other reason than that it stimulates speculation on what might happen in the future, based on what has happened in the past.
During 1990 and 1991, the UK was in the grip of a recession. Equities suffered but rebounded handsomely over the next few years. The high-yield bond market was set to do the same but what is more astonishing is the fact it actually outperformed equities and gilts during the next two years, as shown in the table.
The same occurred in the US, which can be seen in the performance of the Merrill Lynch High Yield Bond Index, a more accurate measure of high-yield bonds than the Other Bond index. In fact, the rebound was even more remarkable in the US, although it happened a year earlier because the US emerged from recession ahead of the UK.
While I am not saying high-yield bonds will repeat this outperformance, there are some interesting comparisons. In the early 1990s, the inflation rate was coming down, paving the way for lower interest rates and an improvement in the bond markets. Inflation is already low and, in my view, is set to stay low in the medium term, allowing interest rates to remain low and stable. This has already led to an appreciation in gilt values.
We have probably seen much of the performance to be had from the gilt market so any further outperformance is likely to be in the corporate and high-yield bond sectors, which would benefit from the falling default rates. The only concern is how protracted the current slowdown will be, although people were asking a similar question in 1991.
A holder of corporate bonds is being paid a significant risk premium because of the current environment when, in fact, the future may be far less bleak. The global economy may finally be dragging its sluggish frame out of the downturn, albeit at a slow rate. Notice how the default rate on speculative grade bonds halved between 1991 and 1992 as recovery began to take hold. One cannot say the same will occur in 2003 since the economic recovery is likely to be more muted, but we have probably reached the peak in defaults.
Within the UK, many of the likely default candidates have already committed the evil deed. The default rate could fall for the simple reason that those most likely to default have already done so. NTL and Marconi are comfortably behind us. Colt Telecom is probably the only technology, media and telecoms start-up within the UK that remains.
Outside the UK, France Telecom is looking shaky but its problems have been well documented. Indeed, we may look back on the high number of defaults and corporate failures as having been a necessary, but useful, evil. It has exposed the weaker companies, leaving those remaining more likely to meet their obligations to bondholders.
Moreover, the corporate climate is changing. The late 1990s saw corporate excesses and credit quality took something of a backseat as companies undertook expensive merger and acquisition deals, often backed by financial debt instruments.
This year is a very different environment. Companies are being praised for financial discipline. Investors are no longer in the mood to finance expensive deals and companies are being applauded for reducing their debt levels. This is playing into the hands of bondholders. Across the credit spectrum, investors can demand more stringent covenants before they will support an issue.
The current spread of investment grade and speculative grade yields over gilts and US Treasury Bills is extremely generous. Investment grade bondholders are being paid up to 2% more at the BBB level and around 1% at the AA level to hold corporate bonds rather than government issues. With a projected investment grade default rate of 0.18% for this year, these seem very generous yields and suggest investors are being over-compensated.
Similarly BB-rated high-yield bonds are offering 5% more than the government issue, with spreads rising towards 8% plus for single B-rated bonds. Obviously, the threat of default is a lot higher, but any improvement in the default rate, as happened in 1992, could see a significant lift in bond prices as their high yields would be attractive in a low interest rate environment.
However, therein lies another issue surrounding the high-yield bond market. Only a couple of months ago, it was a brave man who would bet against a rise in interest rates. Recent market volatility and patchy economic figures have led to a shift in consensus as the arguments for low interest rates to support the fragile recovery gain the upper hand. If low interest rates persist for some time , this can only be of benefit to bondholders, whose higher yields will seem all the more attractive.
Providing inflation is kept in check, interest rate rises should remain fairly modest. Pricing pressures in the economy generally appear weak. With producers currently having little pricing power and surveys suggesting house price inflation may be peaking, the inflationary outlook appears favourable for bonds.
While spreads for speculative and investment grade corporate bonds are currently high, their durations tend to be lower than gilts, which makes them less sensitive to interest rate rises. Indeed, high-yield bonds may benefit if sentiment on the economy improves, as investors move out of gilts and investment grade in search of the better yields. This would especially be the case if the default rate falls, or if it is anticipated to fall, since the bond market will respond rapidly to more optimistic sentiment.
Uncertainty surrounding company earnings may be reducing. The signing-off of accounts by CEOs in the US and the market's unforgiving attitude towards any company caught in financial impropriety should lead to clearer accounting and earnings visibility going forward. This can only serve to lower the risk premium for both bond and equity holders. The introduction of FRS17, the accounting standard that demands a company reports its pension surplus/shortfall in its accounts, will further enhance visibility
We may be going through a structural change where investors, both institutional and retail, feel more comfortable holding bonds. Life assurance companies have been buying bonds to improve the diversity of their holdings, which were generally biased towards equities.
Even if equity markets rally, many insurance houses are unlikely to reverse their purchases of bonds, having had their fingers burnt so badly by equities in the past couple of years. With FRS17 and the change towards defined contribution pensions, there is a shift by many pension trustees towards a greater weighting in bonds, which is likely be ongoing.
Similar moves are afoot among retail investors. Poor returns from equity markets are awakening investors to the benefits of a more diversified portfolio. For many people, investing was a polar choice between a savings account or equities. With bonds offering a higher return than can be obtained from a traditional savings account, coupled with the potential for capital growth without assuming the level of risk associated with equities, many people are coming round to their merits.
A bond fund is also the perfect option for those looking for income. Having overlooked income during the tech bubble, investors are waking up to the benefits of receiving a regular payment, which no doubt helps explain the growing popularity of equity income and bond funds.
Companies that pay a generous dividend cheque or funds with a regular income payment may certainly find their investors are a lot more forgiving. Such payments can make a short-term loss of capital seem more palatable, encouraging investors to stay the course, which, in the long term, is often the most profitable strategy.
If, like me, you share the view that we may be over the worst regarding corporate scandals and the economy is likely to slowly improve, and with it corporate prospects, then a bond fund offers an interesting, and perhaps safer, play than an equity fund. There can be no better time to invest in corporate and high-yield bonds than on the cusp of a recovery, so investors could be looking forward to some healthy gains.
We have probably seen most of the performance to be had from the gilt market.
A holder of corporate bonds is being paid a significant risk premium because of the current environment.
If low interest rates persist, this can only be of benefity to bondholders, whose higher yields will seem more attractive.
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