Credit markets outperformed last year compared to the other asset classes, despite a background of slow global growth and defaults
Last year was an odd one for the UK corporate bond market. The environment was far from favourable: global growth slowed as the world's largest economies fell into recession; stock markets were plummeting and corporate defaults and ratings downgrades jumped to levels not seen for a decade.
But despite this unwholesome background, credit markets put in a performance that was reasonably good in an absolute sense and frankly excellent relative to most other financial asset classes.
The UK investment-grade bond market generated a decent positive return for the year, outperforming both gilts and equities. And even the high yield bond market, widely regarded as a very risky asset class, declined only 8.7% ' performing considerably better than the stock market, where the FTSE 100 fell 13.2%.
This outperformance naturally raises several questions. How did corporate bonds manage to perform so well last year when the backdrop was so hostile to corporate credit? Will corporate bonds be able to repeat last year's impressive performance this year? And what should investors do now?
The strong relative performance of corporate bonds last year came about because of a combination of three important factors that overwhelmed the effects of those defaults and credit downgrades that grabbed the headlines.
Credit spread is the extra yield offered by corporate bonds compared to the gilt yield. If corporate bonds yield 6% when gilts yield 5% the credit spread is 1%. It is a reflection of how much extra risk investors think they face from holding the bonds of companies rather than those issued by the UK Government.
Credit spreads were still large by historical standards at the start of 2001. They had hardly come down from the levels reached after the 1998 shock collapse of the LTCM hedge fund. The average yield of the investment-grade corporate bond market (which has an average credit rating of high single-A) was nearly 1.5 percentage points higher that the gilt market yield.
This extra yield gave investors a substantial cushion over gilt yields as a reward for taking the credit risk of the non-government bond market rather than buying gilts.
Therefore, even if credit spreads had simply stayed constant throughout the year, the corporate bond market would have outperformed gilts by about 1.5%, purely because of the additional yield.
The decision of the Boots pension fund trustees to shift their entire portfolio into long-dated high-quality bonds has been widely discussed: but it was only one example, albeit a very prominent one, of a more general asset allocation shift. Recent regulatory changes and influences have a significant role in driving investors towards corporate bonds.
First, demographic considerations are pushing many pension and life funds to reallocate more assets into long-dated fixed interest, to meet actuarial or prudential requirements. Second, there are regulatory pressures.
Most notable is the forthcoming introduction of the FRS17 accounting standard, which will require companies to include on their balance sheets changes in the value of the company's defined benefit employee pension fund.
These sort of factors are encouraging pension funds to reduce the volatility of their portfolios by increasing their allocation in fixed interest by reducing equities (where pension funds have traditionally been rather over-exposed).
Finally, the decision of accountancy professionals ' and the Myners review of the minimum funding requirement ' to recommend using a AA-rated bond yield to discount pension funds' future liabilities has funds a further incentive to hold AA-rated bonds in preference to other assets.
These different factors add up to a longer-term shift in the regulatory environment that is generally supportive of corporate bonds. But they do not wholly explain why corporate bonds did as well as they did last year, particularly in light of all those downgrades and defaults.
Those downgrade and default statistics certainly make quite scary reading. Corporate default rates are as high as they have been since 1991. Standard and Poor's, one of the leading credit rating agencies, reports that during the past year it downgraded 4.4 times as many European Union borrowers as it upgraded.
The worst culprit was the telecoms sector, which had more debt downgraded than any other sector: more than E200bn of telecom debt was downgraded during 2001.
How do we square the deteriorating credit quality of the market as a whole, and in particular of the telecoms sector, with the market's high excess returns, whose best-performing sector was, ironically, telecoms?
The answer ' and it is an answer that should illuminate the prospects for the market in the year ahead ' is to do with valuation. In a nutshell, corporate bonds did well because they were too cheap ' particularly the telecoms sector.
The chart to the left may help to explain why. Using Morgan Stanley data, it shows the annual excess return over gilts of the various sectors of the non-gilt sterling bond market. The average excess return of the non-gilt market as a whole is also shown: it is the black dotted line.
Looking at the performance for 2001, it is notable not only that the market as a whole outperformed gilts (which has not been unusual in the past five years, as the chart shows), but that every single sector of the market outperformed. This is less usual: as the chart shows, in any given year, some sectors will outperform while some underperform. The fact that all sectors outperformed during 2001 demonstrates a generalised re-pricing of credit risk in the bond market.
In the light of what we know about the deterioration of the market's credit quality, this needs explaining. And the explanation is that the deterioration of credit quality recorded by the rating agencies during 2001 was, on the whole, already anticipated by the market when the year began. It was, as they say, already in the price.
Consider the most extreme example of ratings downgrades and outperformance, namely the telecoms sector. The chart shows very clearly that telecoms underperformed massively during 2000, thanks to such excesses as the prices paid at the auctions for the G3 mobile phone licences. During 2001, telecom companies to experience ratings downgrades, but by then the market was already treating telecom debt as a much worse credit than its then current rating implied.
This is a classic example of market-imposed discipline benefiting corporate bond holders. Because of the bond market's increasing scepticism regarding the telecom sector's expansion plans, and its demands for higher and higher yields to compensate for the added risk, telcos eventually had to scale back their plans. They were forced to think about rebuilding their balance sheets.
At that point, even though the rating agencies were still downgrading the telcos' debt ratings, the real risk on telecom debt defaulting was starting to fall.
As the large telcos' credit ratings deteriorated quite sharply, more grandiose expansion plans have had to be scaled back and, as such, the outlook for their creditworthiness has improved. As a result, the telecom sector of the corporate bond market has taken back all of last year's losses and then some, despite the credit downgrades. To a lesser extent, this was true for the whole market during 2001.
the Year ahead
So, what does all this tell us about the year to come? Well, things will not be quite so easy for the corporate bond market this year.
First, the very fact that corporate bond prices rose and credit risk premia fell during the course of last year means that they inevitably start off lower this year. Whereas the corporate bond market's excess yield over gilts was about 1.5% at the beginning of 2001, it started this year at less than 1.25%.
This is still a substantial margin and still points to an outperformance, but this contribution to excess return will be smaller this year than it was last year.
The longer-term structural and regulatory drivers of increasing demand for fixed income assets in general and for corporate bonds in particular are still in place, which will be supportive of corporate bond returns.
We saw last year that the corporate bond market anticipated the end of corporate borrowers' credit deterioration, even as the ratings agencies continued to downgrade them. It must be assumed that the credit markets are no less forward looking today. Thus, one must assume that the market has already priced in at least a modest chance of the widely forecast 2002 global recovery.
If the recovery does materialise, it may not therefore be greeted in the corporate bond market by substantial further outperformance ' though doubtless the stronger the recovery, the better it will be for corporate excess returns. Of course, the high yield market is more highly geared to the economic cycle and will substantially outperform if the recovery is stronger than expected.
All in all then, corporate bonds can be expected to outperform gilts again, but perhaps excess returns will be more modest this year.
Despite the wholesome background, corporate bonds put in a reasonably good performance in an absolute sense.
Demographic considerations are pushing pension funds into long-dated fixed interest.
High yield market highly geared to economic cycle and will therefore outperform if recovery is stronger than expected.
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