UK corporate bonds have begun to show value, with equity market volatility driving spreads on govern...
UK corporate bonds have begun to show value, with equity market volatility driving spreads on government bonds wider, particularly among lower-rated investment-grade credits.
With little corporate issuance in the pipeline for the rest of the year, despite continued demand from investors and financial health improving among issuers, market watchers believe now is the time to buy before spreads tighten again.
Fidelity senior portfolio manager Ian Spreadbury says spreads have widened among BBB, A and high-yield bonds in response to stock market volatility and the absolute level of equities as investors price in greater risk of default.
'Historically, it has been a significant factor that whenever you see a rise in equity volatility, spreads widen as a result,' he says.
'But there is evidence companies are restructuring and deleveraging. Looking forward, that would be a positive factor for spreads tightening.'
After gearing up in recent years to chase higher returns for equity shareholders, companies are now trying to clear debt from their balance sheets, while merger and acquisition activity, a key source of financing demand, has dried up amid general corporate conservatism.
But demand is set to remain strong, with pension funds stepping up their corporate bond investment to meet FRS17 requirements on liability cover. Analysts suggest the changes will see around £10bn shifted annually from equities into bonds in the UK.
Jim Leaviss, head of retail fixed interest at M&G, says: 'With that much money moving into the asset class every year, we cannot see the market selling off significantly.' Another positive for spreads is that the balance of issuance is likely to swing increasingly towards governments as public spending increases, pushing yields on gilts towards those of corporate bonds.
'It is typical at this stage of the cycle that corporate issuance dips a bit and government issuance picks up,' Spreadbury says. 'The net effect is that spreads will probably tighten.'
Aberdeen head of fixed interest Rod Davidson believes the chance of further easing in US official interest rates should help buoy the sector.
'With the Federal Reserve once again moving to an easing bias, we would expect investor sentiment to improve over the next few months,' he says.
Leaviss notes one area of particular interest in the UK is asset-backed securities, backed by either physical assets or cashflows, which can offer additional security to uncertain investors.
'It is an under-researched and technical area,' he says. 'The bonds are heavily covenanted. There's a lot of legal work that needs to be done to be certain you actually have a call on the assets if things do go wrong.'
However, with default rates having risen over the past year, there is no substitute for in-depth credit research and thorough diversification.
'The outlook for the market as a whole is good but there are so many landmines out there and you only need a couple of those to wipe out a lot of performance on your portfolio,' Leaviss says. He recently increased the number of bonds in his portfolio by more than 20% in order to further diversify.
Spreads have widened recently.
Corporate issuance drying up.
Demand from pension funds.
Default rates have risen.
Some bond issues very technical.
Important to pick the right bonds.
Paul Bruns and Elaine Parkes
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