Corporate bond managers have been positioning their portfolios towards higher yielding stocks in com...
Corporate bond managers have been positioning their portfolios towards higher yielding stocks in companies not at risk of defaulting if leverage buyout activity occurs (LBOs).
Simon Surtees, manager of the Gartmore Sterling Corporate Bond fund, has been positioning his fund to be overweight short-end bonds because they are higher yielding than long-dated bonds.
He says: "The credit curve is not steep enough and investors are not being rewarded if they invest in long-dated maturities. Short-end bonds will benefit the most when the credit curve steepens as inflation creeps up and rates rise."
Surtees is only investing in stocks with a low risk of default. These include vehicle manufacturer General Motors and Canadian aerospace company Bombardier. He explains that when the curve steepens the default rate will rise from LBOs, therefore, if an investor has purchased a bond used to fund the LBO, there is a risk they could lose their money if the company can not pay back its debt.
A similar view is echoed by Jim Cielinski, portfolio manager of Goldman Sachs Asset Management. He explains a higher yield should create opportunities for managers who can pick the right bonds and avoid defaulters. He warns a marginal increase in defaults could cause problems for investors holding the wrong paper.
He says: "Many lower grade companies are working to improve their balance sheets, unlike many investment grade companies and picking the right bonds will be crucial going forward from here.
"Default rates are inversely correlated to economic growth and a significant number of companies who have issued higher yield bonds over the last three years will default if economic growth slows materially."
Cielinski, who manages the Lincoln Corporate Bond trust, has positioned the product to be overweight companies where the risk of default is limited. One sector he is favouring is telecoms as companies have been paying off debt for more than two years, yet bond valuations have failed to fully reflect their financial strength. Although the sector has been beaten up when the technology bubble burst, it promises good cashflow unlike the market and Cielinski does not expect it to quickly return to higher levels of leverage.
Canada Life's strategy for its pension portfolios is also underweight companies which could become potential LBO targets.
Patrick Schoeb, fund manager at Canada Life, says: "While the corporate sector is in good health and credit spreads are low, risks should increase for companies in 2007 as some re-leverage and merger and acquisitions activity picks up. For this reason companies involved in LBO activity which could potentially under perform should be avoided."
In contrast, Stephen Snowdon,manager of the Old Mutual Corporate Bond fund, favours corporate bonds involved in LBO activity. However, he is showing a bias towards companies that have strong covenants and can protect bond holders from financially damaging actions.
He explains: "Corporate bonds have had the added woes of LBOs and tight spreads, or so the consensus would have it. There is no reason why LBOs should present undue concerns for an active bond manager. They can be good for bonds with strong convenants that can protect bondholders from financially damaging actions. I hold several names rumoured to be targets, including builders Taylor Woodrow and transport company FirstGroup. Both have strong covenants requiring any predator to buy the bonds back, giving a healthy premium to bondholders."
LBOs could increase default rates
Good covenants should be protected
Funds positioned in stocks with low default rates
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