Corporate bonds should still see a good return over the next 12 months but companies will have to be more careful about their selections after a recent sharp re-pricing suggested the bonds bubble had finally burst, says F&C.
Ian Robinson, manager of the high income bond fund at F&C Asset Management – which invests only in investment grade debt – says while yields have consistently fallen since the second half of 2004 and dipped considerably in February this year, this was not the start of a major downturn.
The bonds markets has since improved since the earlier blip, says Robinson, as investment grade yields have pulled back 50 basis points to 6%, while European high yield bonds have seen returns rise from 4.5% to 5.5% and B-rated credits (sub-investment grade) are now even higher, having gained 100 basis points to 7%.
Part of the reason the bond sector has improved rather than fallen, as previously anticipated, is bonds have yet to go through the credit cycle asset allocation phase, which sees debt growing faster than profits, as is usually the case before a market faces losses.
When the telecoms market collapsed at the turn of the millennium, bond issuers, such as France Telecom, were forced to enter into a major debt restructuring programme as similar companies had previously seen their debt grow faster than profits and the cost of debt was too high to be a good investment for companies.
Since the restructuring, companies have been in a stronger position and spreads have improved because companies are more stable and profits are now growing faster than debt and are perhaps, in a position to consider riskier activities thanks to increased confidence.
At this stage in the cycle, companies have yet to take on those larger levels of debt, says Robinson, and income and bond funds still look attractive as there is no immediate sign of the bond bubble bursting.
“We are still not at the point where debt is growing faster than profits. There was a pause and slight concern that profits won’t grow as well as expected,” he says.
But one of the reasons the corporate bonds yields have grown is some of that excessive risk-taking has been unwound. Now is the time to buy credit again because these yields are more attractive, albeit this time we need to be more selective,” adds Robinson.
Fatima Luis, head of retail credit at F&C, points out the first quarter of this year has been the most active in terms of historical new issuance into the high yield bonds market, as the possibility of M&A activity becomes a stronger.
‘Triple C-rated’ or high yield bonds, in particular, have seen “overly optimistic” issuance, says Luis, who manages some of the higher risk strategic, extra income and maximum income bond funds – which also invest in high yield debt – as a total £9.8bn worth of high yield bonds came to the market and 50% of those were CCC-rated.
Companies given a CCC rating may not actually be particularly at risk of default, as they tend to be stable companies but simply carrying too much debt.
That said, there is one advantage to these bonds, points out Luis, as they carry a ‘change of control covenant’ which ensures bondholders get a premium payout if the issuing company is taken over and bonds are subsequently downgraded.
Use of these covenants could spill over into the investment grade bonds markets in the short term, suggests Robinson, as issuers now find they need to offer something a little extra to make bonds purchase more attractive, given the tight spreads in a low inflationary environment.
“I suspect over the next few months we’ll see these covenants coming into being much more, in order to get bonds issued on the market,” says Robinson.
“It would be the first time in a while we have been able to call the shots, but it is highly unlikely to be sustained because there has been a continuous demand for bonds in the UK, and they are only now experiencing that demand in Europe.”
Robinson points out the liquidity of the investment grade corporate bonds market is set to experience pressure from European pension funds, as reform in the Netherlands of accounting liability requirements will force companies to adopt rules similar to FRS17 and the EU’s Capital Adequacy Directive, which require a fund’s liabilities be clear and attainable.
While this could place pressure on the UK market too, if there is increased demand for strong investment grade bonds to cover pensions liabilities, Luis suggests that problems could be solved by the potential growth of asset-backed bonds.
There have been calls over the last year for the development of a European mortgage-backed bond market, to help improve the prospects for long-term mortgage interest rates.
However, growth of asset-backed credit could help alleviate the pressure on the UK bonds market as pension funds could buy these bonds and lock them away to cover long-term liabilities.
At this stage, F&C is still waiting for spreads to stabilise before getting back into the market, but careful selection of quality names could continue to generate good returns for all of its funds, says Luis, including the strategic bond fund which is the best performer in the UK unit trust corporate bonds retail sector over five years.
“We are still waiting for spreads stabilisation before re-entering the market and have held cash. It is better to go for shorter durations in terms of the maturity of the bonds held. We are still slightly over weight on high yield, because they should benefit from M&A activity. While cash holding is 7% at present, it was as high as 10% earlier in the year.”
Top ten performers in the UK unit trust/OEIC retail corporate bonds universe over five years
|Company||5-yr Return (%)||Rank|
|F&C Fund Management strategic bond S1||51.25||1|
|Invesco Perpetual corporate bond||42.27||2|
|Aegon Asset Management UK plc extra income||40.94||3|
|Abbey National balanced portfolio income||40.68||4|
|New Star Investment Funds sterling bond||36.96||5|
|Royal London income||36.39||6|
|Fidelity moneybuilder income||35.67||7|
|Norwich Union corporate bond cl.3||35.60||8|
|Legal & General managed income||35.14||9|
|Gartmore Fund Managers corporate bond||34.48||10|
Source: Financial Express Analytics, bid-to-bid, overall return, to 12/4/05
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