Investing in any asset class poses its own set of risks however, Peter Hicks looks at the possible opportunities to be found in fixed income
Anyone who thought before the financial crisis that fixed income was an inert asset class might now be forced to reconsider their views. Far from offering immunity from the volatile prices of other investment assets, fixed income, both corporate and government, has been buffeted by the financial storm.
In their droves, investors have sought security from capital risk and so have invariably plumped for the sovereign guarantee that gilts offer. This has pushed gilt yields to very low levels as the buying momentum has lifted prices. To add to that, quantitative easing has catapulted central banks into the US, Sterling and Japanese gilt markets with the buying power of a millionaire in a pound shop.
One session in March saw the UK 10-year gilt yield swing 25 basis points, perfectly illustrating that volatility is not confined to equity markets. A 20 basis point spike greeted the failure of a 40-year gilt auction (the first for some years) which was caused by a lack of investor interest. This worried people who are concerned about investors' appetite for the glut of new issues in the future. By the end of the session, the yield rested five basis points down after the Bank of England's latest tranche of quantitative easing purchases took place in the afternoon. Such a large swing is rare and for much of the past decade would have been considered the norm for a year rather than within a single session.
An already complex landscape was made more so when the following day, an index-linked issue with a 13-year maturity was three times oversubscribed. The upshot of gilts' general popularity among risk-averse investors is that the benchmark 10-year gilt yield has settled at around 3% which is lower than it has been for many years.
Conversely, the worry of corporate default has had the opposite effect on non-government debt. Investment grade corporate bonds are currently yielding more than 9% (higher than for many years) and the redemption yield on sterling high yield bonds has topped more than 30%. At such levels, investors are pricing default at similar levels to that experienced during the Great Depression. Although there is an expectation that defaults will rise as the recession bites, our view is that such extremes are unlikely.
The current bubble
Bond investors need a clear investment strategy to see opportunities through this blur of information. Income seekers should be aware of the risks of chasing high yields, but also mindful of the potential opportunity today's market presents. Investors seeking shelter in government debt should be mindful of the current popularity of the asset class especially since it has prompted some to suggest that gilts are a current bubble.
Billions of pounds have been created to grease the cogs of the financial system through buying predominantly government debt. Without doubt, quantitative easing has been the biggest event of recent weeks for fixed income.
So far, these plans have achieved what they set out to and but for the sudden and short spike caused by March's failed auction, gilt yields have fallen since the programme began. This might well turn out to be a good sign for economic recovery, but not so for income-seeking investors for whom the falling yield makes gilts unattractive despite the security they offer. For them, the additional risk associated with corporate bond investment might be worthwhile.
For some months, corporate bonds have offered a strong yield at an acceptable level of risk, if defaults are avoided. This remains the case. Quantitative easing's impact on the corporate bond market will be less dramatic than its influence on gilts because the buying bank's plans concentrate on the domestic market. Corporate bond markets, unlike government bonds, are international.
Avoiding defaults is the challenge of corporate bond investment strategy and only very careful selection of debt issues based on thorough fundamental research will ensure this. A closer look at some specific opportunities available today illustrates what value exists among some exceptionally strong companies.
Here are a few examples of corporate bonds that have caught our eye in recent weeks. They offer the certainty of capital gain if held to maturity and a very attractive yield until then. First is a Tesco 5% issue that matures in 2023. Trading at 93, the redemption yield is 5.7%. Next is National Grid 5.875% 2024. At 97.3 its redemption yield is 6.1%. For the contrarian investor, an RBS 6.934% 2018 is priced on the floor at 68.1 and so yields a barely believable 13.2%. Yes, RBS is in distress, but with the government's backing and a stated wish not to take further equity in the company, the longer term future of the bank is better than at the start of the year.
Extreme valuations and stresses in many asset classes are the likely cause of some asset allocators' views that bonds are the 'new equity', replacing shares as the predominant asset class in growth portfolios. Such unconventional arguments are common at inflection points in markets when uncertainty and a lack of confidence and direction overcome established market beliefs.
More likely in the future we will find our way through the financial crisis, the yield spread between corporate and government bonds will return to more normal levels, at which point, any investors to have taken advantage of pricing anomalies will have enjoyed healthy gains.
It was debt of one form or another that triggered this crisis and the spending plans of governments around the world suggest that it will be debt that gets us out. While today's stresses remain in fixed income markets, careful investors can find opportunity.
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