While it has been undoubtedly a difficult year for global equity markets, corporate bonds have also found the current environment very tough. Prior to the credit crunch, corporate bonds had enjoyed a period of good performance as the spreads compared to government stock tightened significantly, including for lower-rated or sub investment grade credits. Corporate bond spreads in this case refer to the difference in the yield between the bond and a risk-free investment such as government stock. When the spread widens, the market is factoring in a greater chance of default by the corporate bond issuer.
Corporate bonds have been an attractive investment for more risk adverse investors and they have been rewarded prior to the credit crunch from a period of historically low levels of defaults. This aided the tightening of spreads, the relatively low level of Government yields, robust corporate earnings growth and a favourable demand/supply position.
However, since mid-2007, corporate bonds have endured one of their worst periods on record with the average investment-grade corporate bond fund falling by over 10%. The main reason behind this sharp fall is that concerns over corporate failures increased significantly and this led to fears over a sharp rise in defaults. Another negative impact has come from the forced selling by other funds such as hedge funds that have needed to raise monies to repay borrowing.
Liquidity in the credit markets has dried up dramatically and this has led to problems in pricing bonds, particularly lower rated issues, and this has contributed to corporate bonds being priced at levels not seen for decades. This sharp decline in prices has led spreads to significantly widen with the market effectively predicting that greater than one in three of all investment-grade companies will either default or go bankrupt in the next few years. This would represent a huge increase in default rates as the worst rate in recent history has been only one in thirty-five.
While we have seen an increase in investment grade companies hitting financial difficulty this year, e.g. Lehman Brothers and AIG, it could be viewed as unlikely that we will witness an increase to one in three companies, even when allowing for a possible deep recession in the UK. It should also be remembered that when companies do get into financial trouble, bondholders will do better than shareholders as they will often receive at least some money back.
Although the short-term outlook is likely to remain volatile with liquidity remaining tight, corporate bonds now appear good value compared to government stock, particularly when taking a medium-term view and if you don't believe that default levels will reach such high levels.
At Origen, we recommend the use of investment funds to provide exposure to corporate bonds. As corporate bond funds will invest in a portfolio of different issues, this reduces the impact of defaults on the investment. There are three main types of corporate bond fund, namely investment-grade, high yield and strategic with the latter fund allowing the manager to invest in a mixture of high yield and investment grade and, therefore, have the greatest exposure to those credit issues that they believe offer the best value.
Investment in any particular corporate bond fund will depend on the underlying risk profile of the investor as the greater the exposure to high yield issues, the greater the risk of default.
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