While the corporate bond sector has outperformed equities in recent years, the asset class is still exposed to market volatility and stockpicking is key to beating the market as a whole
While investment grade corporate bonds outperformed gilts last year, we have seen unusual levels of volatility, both at the sectoral and issuer level.
The frenetic pace in markets caused by the difficult economic and corporate earnings environment has driven investors to wheedle out the winners from the losers dispassionately and with ever increasing ferocity. Indeed, those corporate bond funds outperforming in 2002 would likely have done so by avoiding the losers.
The supply and demand picture differentiated the returns of investment grade corporates from government bonds, with demand from pension funds (prompted by FRS17) keeping positive downward pressure on investment grade yields.
At the same time, a virtual doubling of government borrowing to £20bn, announced in the chancellor's pre-Budget statement, triggered expectations of additional gilt issuance. This threat of additional supply weighed on gilt prices.
Slowing economic growth and earnings caused the percentage of companies unable to meet their debt commitments to increase. The notable underperformers were financials (specifically insurers), utilities and telecoms. However, the latter managed to stage a recovery later on in the year.
The problems facing the insurers are well documented. The overriding necessity to balance the asset base against liabilities meant many became forced sellers of risk assets in a bear market.
Falling share prices brought solvency margins under pressure, affecting the insurers and general financial services companies with insurance businesses, because of the expectation that these subsidiaries would prove a capital drain on the firm.
Utilities also suffered, specifically because wholesale energy prices fell to levels significantly below the cost of production. This resulted in the collapse of British Energy and, in the fourth quarter of 2002, problems at TXU.
Telecoms suffered from problems at WorldCom, which placed a temporary question mark over the industry's accounting practices (specifically those relating to transfer pricing). However, initial fears of contagion proved ill-founded and the sector has recovered strongly.
Interestingly, the risk profile of corporate bonds as an asset class is moving to a par with equities as the drive to separate the winners from the losers escalates.
In fact, high-yield credit defaults have moved to a higher level than at the peak of the last major recession in 1991. This is largely a symptom of the boom in capital spending of the late 1990s, which saw a raft of technology, cable and telecoms (TCT) issuers raising funds in the bond market for infrastructure build out programmes.
This issuer bias has been a particular problem for the European high-yield market, which is much smaller and less well diversified in terms of its industry profile than US high yield. These capital constrained companies face high competition within sectors that have failed to achieve subscriber volumes of the order necessary. As companies exhaust their capital raisings, defaults have increased.
Issuer-specific risk is also high in the US, but its diversity of issues means that we believe there is some value, given the double-digit yield advantage over Treasuries.
However, in our view, picking the winners from the losers within sectors is becoming nigh on impossible, given the order of magnitude of volatility.
Here we believe that diversification is key, because carefully managed exposure could prove fruitful if, as we believe, yields are discounting an overly pessimistic economic scenario.
We support the view that the economic outlook will remain weak, which we believe underpins the rationale for a healthy allocation to bonds. The global economy is fighting a number of significant headwinds, given the geopolitical risk, the precarious state of both the US consumer and UK consumer.
Confidence for the latter has been underpinned by growth in house prices. Any increase in unemployment could take the shine off of confidence and house prices, taint the outlook for UK demand.
We expect inflation to remain subdued and, while the threat of war raises the prospect of a short-term spike in the oil price, we are not overly concerned and believe Opec's range of $22-$28 per barrel is likely to be indicative of the long run price trend. The economic environment is conducive to further interest rate cuts globally, and certainly there is plenty of room for the Bank of England to act is need be, with rates high in absolute terms relative to other developed economies at 4.0%.
Our supply outlook varies by credit quality with UK government bonds likely to come under pressure from further issuance, required to fund increased public borrowing. This issuance is likely to come in the form of longer-dated bonds, causing the yield curve to steepen.
As government issuance increases, swap spreads should tighten ' a positive scenario for credit. Unlike gilts, the supply and demand picture for investment grade corporate bonds is likely to continue to be supported by pension funds, given the guidance FRS17 has provided this year.
Global high-yield debt has underperformed dramatically, but we believe that the asset class is potentially oversold and might represent relatively good value. The key seems to be how to gain exposure to the potential returns whilst maintaining an appropriate risk profile.
From our perspective, the US high-yield market is mature enough to weather the current storm. We believe issue selection is absolutely vital, but company-specific risk has risen to unprecedented levels within high yield.
In our retail fund, DWS Corporate Bond Plus, we choose to manage a best of our best ideas portfolio in the investment grade portion of the fund, which consists of around 50 issues.
Within non-investment grade, we are cautiously optimistic about the outlook for the asset class and believe the yield pick up compensates for the (albeit historically high) default risk.
However, the market is simply too volatile to pursue a best of our best ideas approach, so we are sticking to a big list of names we know and trust as a result of our analysis and relationships.
Even with the superior credit research resources of DWS Investments at our disposal, we opt for diversification within our US high yield portfolio, through some 150 issues. In addition, high yield bonds represent less than one fifth of the assets of the Fund.
We remain relatively lightly represented in financials through the insurers, although we see some value among the UK banks. The key risk to this stock specific view is the consumer.
A deteriorating picture for house prices and/or employment would impact on the outlook for economic growth, with a knock on effect for non-performing loans in the banking industry.
We like industrials although we are sceptical about the potential of cyclically sensitive areas within this area for similar reasons to those quoted above.
Among the highest quality corporate bonds, we hold a positive view towards selected asset-backed securities (ABS), which have defensive qualities we believe to be attractive given the increase in volatility in the asset class.
These issues offer credit ratings of similar quality to supra-national debt. However, they offer yields of the order of LIBOR +25 basis points, as opposed to the LIBOR ' 25 basis points typical of the supra-nationals.
Another attractive feature of ABS is the peace of mind that the link to a specific ringfenced asset of the issuer provides, increasing the potential the holder has of recovering some capital in the event of default.
The key to cracking the ABS market is the capacity for in-depth issuer research because it takes a large and experienced team to do the leg work required to uncover the issues with most promise.
In 2002, slowing economic growth and earnings caused the percentage of companies unable to meet their debt commitments to increase.
The US high-yield market looks mature enough to weather the current storm.
Issuer bias has been a particular problem for the European high-yield market, smaller and less well diversified than in the US.
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