Faced with dire losses from equity markets investors have turned to the stability, transparency and liquidity of the corporate bond market
Rarely has there been such intense and sustained interest in the corporate bond market. There are many reasons for this but perhaps the most compelling is investment returns, and very consistent returns at that.
The performance of the corporate bond sector is not mere statistical fluke aided and flattered by the extreme volatility of global equity markets and the dramatic slump in share values.
Indeed, despite the lurid headlines accompanying the large-scale corporate disasters at WorldCom and Enron this year, and, closer to home and for different reasons, Railtrack and Marconi, corporate bondholders have generally fared better than equity investors in the same company.
Of course, there are risks in holding corporate bonds, just as there are with equities. But as disposals and liquidations continue, corporate bondholders, along with other lenders, stand to benefit ahead of ordinary shareholders.
To put the size of the corporate bond market into perspective, it has increased from £25bn in 1990, or 16% of the total market capitalisation of UK bonds, to more than £225bn at the end of last year.
The increased investor appetite for corporate bonds has come from right across the investment spectrum, with retail unit trusts doing particularly well in lifting sales against the general trend.
In July, for example, the UK unit trust corporate bond sector was the most popular, according to figures from the Investment Management Association, accounting for 14% or £320m of gross retail investment.
The Merrill Lynch investment grade corporate bond index shows the total return on corporate bonds so far this year has been 7.1%. This compares with an average yield of 6.6% on UK gilts. Over three years, corporate bonds have returned 17.6% in absolute terms. On the same basis, equities are firmly in negative territory, down by 22% this year alone.
Faced with such dire losses, investors, advisers and trustees have been forced to look seriously at portfolio diversification. But finding an asset class that provides stability, transparency and liquidity, and meets so many different risk parameters, is not easy. This is where corporate bonds come into their own.
While equities enjoyed their day in the sun during the stock market bull run of the late 1990s, the corporate bond market was slowly but surely gaining recognition among investors. Never flash and often thought of as a bit like the reliable old Volvo ' stable, safe, and secure ' the corporate bond universe has evolved into a dynamic asset class with much to offer.
What has undoubtedly helped, in the past few years at least, is that banks and finance houses, the traditional providers of so much liquidity in the corporate market, have taken a step back. They are still in the market but in a low interest rate environment companies have found it much cheaper and, in many ways, more satisfying, to raise their money in the corporate bond market.
By going the bond route rather than through finance houses, company executives can plan ahead for up to 30 years, as opposed to much the shorter terms attached to bank loans.
The recognition of the importance of bonds to the corporate world coincided with a move during the 1990s by governments, particularly in the United States and the European Union, to pay down debt and borrow far less from the market. In the UK, for example, this means the supply of gilts has become relatively limited.
Maintaining a low inflation environment and not borrowing too much money will continue to be regarded as prudent and desirable. In the short to medium term however, the general consensus is that governments may yet again need to tap into the bond markets for further funding. This is likely to have a depressing effect on government bond yields for a while.
That aside though, it is possible to look ahead and see renewed stirrings of interest from companies keen to rebuild their balance sheets through debt rather than equity. In turn, this will ensure there is a steady stream of investment opportunities at different levels of the risk spectrum in terms of both exposure and yield.
What has undoubtedly swung investors in favour of at least giving serious consideration to corporate bonds, along with their performance, is that the sector is now well served by benchmarks, against which investors and advisers can make meaningful comparisons. Nothing can ever replace old-fashioned research, analysis, setting risk parameters and face-to-face meetings with companies, nor should it. But, as it increases in importance, so it is right there are independent benchmarks and scrutiny for corporate bonds, including credit ratings from independent agencies such as Standard & Poor's and Moody's. It is of further help to investors to know that in the UK, yields on corporate bonds can be calculated using UK average gilt returns as a reference point.
Perhaps the most significant development for the corporate bond market came as recently as late last year when the trustees of the Boots pension fund decided to switch the £2.3bn portfolio from equities to corporate bonds.
What started out as a rumble, in relative terms anyway, has now turned into a seismic shift in portfolio asset allocation. The Boots catalyst was changes to rules governing the way in which defined benefit pension schemes are run and, in particular, the methods they deployed to calculate future liabilities using the minimum funding requirement (MFR).
The MFR rules mean the assets and liabilities of a pension fund must be better matched and, when valuing future payouts, the fund must use a bond yield as a discount rate. Under MFR rules, the discount rate to be used is the yield on a 15-year maturity gilt.
Even without the MFR rules, trustees and pension fund managers must, in any case, look to future liabilities based on an ageing scheme membership whose life expectancy is considerably greater than when they joined the fund. With double-digit returns from equities a rapidly fading memory, asset classes such as corporate bonds, with good growth potential still to be realised, will become ever more attractive.
If it was MFR and lower equity returns, or even negative returns in the present climate, that gave impetus to the corporate bond market, it is the proposed changes to international accounting rules that mark its coming of age.
The introduction of FRS 17 inextricably links pension funds with a company's balance sheet. Each scheme must measure its assets at market value on the balance sheet date. Pension scheme assets and liabilities are transferred in full to the company's report and accounts.
As with the MFR rules, future liabilities have to be discounted by reference to the bond market, only this time using a AA corporate bond rate as opposed to gilts. The bottom-line, though, is that, in a worst case scenario, the size of a pension fund deficit could actually dwarf a company's profits, and possibly even the value of the firm itself.
It is little wonder, then, that the corporate bond market has awakened such interest. Its merits are certainly better understood nowadays but, even so, there are still popular misconceptions. One in particular is the widespread reference to junk bonds.
There is a mature junk bond market in the US, where such bonds are generally referred to as high yielders. These corporate bonds cover a number of sectors including banks and pharmaceutical companies, so there is much greater diversification than in, say, Europe, where high yielders are small in number and almost exclusively linked to telecoms companies.
Obviously, the higher the yield on a corporate bond, the greater the risk implication. But, as with all investment or asset classes, research is key. It could be argued, for example, that a small exposure within an overall bond holding to a well-diversified high yielder portfolio in the US is sound financial planning rather than reckless risk taking.
The same investment approach could be advocated for emerging market bond funds despite the current turbulence in the Latin American financial markets.
Given their future liabilities, pension funds and their advisers have little choice but to continue their shift out of equities and into corporate bonds. Only time will tell whether, like so many momentums in the money markets, this swing is overdone.
In the meantime, retail investors have a chance to get the best of both worlds through an internationally diversified and well-balanced portfolio of equities and corporate bonds.
Corporate bondholders stand to benefit ahead of ordinary shareholders at disposals and liquidations.
The Boots pension fund's switch from equities to corporate bonds began a trend in the market.
The introduction of FRS17 inextricably links pension funds with a company's balance sheet.
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