Where credit’s due
Despite low liquidity and the prospect of interest rate rises, bond investors are beginning to eye new opportunities.
The corporate bond market in the US accounts for around a third of corporate bonds worldwide and this year US companies have been eager to borrow more to lock in low interest rates. But in recent weeks more opportunities have begun to open up for investors as companies have been obliged to issue bonds with more attractive yields.
Data from Bank of America Merrill Lynch indicates that the average yield on US corporate bonds reached 3.44% at the close of September, compared to just 3.19% over the first three quarters of the year.
High-yield US corporate credit saw an even greater yield jump, reaching 8.22% at the end of last month against a three-quarterly average of just 6.87%. Partly as a result of these increases, new opportunities are emerging.
“The last two years have been about protecting downside after some bull years,” says Paul Read of Invesco Perpetual. “Although it’s early days, value is just beginning to reappear.”
Usually, investors head for the relative safety of bonds during times of economic uncertainty. But as volatility spiked over the summer of 2015, corporate bonds saw outflows instead.
For bond investors, rising interest rates are a constant concern. They chip away at relative returns, making credit a less attractive proposition. Add to that both recent volatility and the poor liquidity currently available in corporate credit, and it would be easy to think the headwinds are too strong. In fact, a number of bond investors feel positive about the outlook.
“You can actually take advantage of these situations,” says Jim Cielinski, head of fixed income at Columbia Threadneedle. “You’ve seen extreme volatility in certain sectors and names; and the flows in and out of asset classes are highly variable on almost a weekly basis – and price action is now quite sensitive to those developments. And if you take a fundamental view, what you’ll often see, even in the bad sectors, are credits that are well positioned to handle a lot of stress. To us, those are the opportunities.”
On the issue of rate rises, Cielinski believes the US Federal Reserve was always liable to move slowly – and that was before last week’s disappointing payroll figures. What the rates outlook does tell him is what kind of corporate credit to look for, namely the shorter maturities.
“One of the basic risks in any fixed-income portfolio is sensitivity to interest rate rises,” he says. “Interest rates are obviously at low levels, and as central bank policy tightens, portfolios with shorter maturities should actually generate positive returns, even with modest rises in rates. In these portfolios you’re insulated much better from rate rises.”
A bond’s sensitivity to interest rate changes is known as ‘duration’. A low-duration bond has relatively low sensitivity to increases.
“The shorter-dated part of the corporate debt market is hugely diverse and very global, and most of the big industries in the market have bonds with zero to five-year maturities, so it doesn’t really limit us,” says Cielinski.
“And one of the unique features of shorter-dated bonds is that you get wider yield spreads, and so you don’t really suffer as much from an income perspective, even though you’re insulating yourself from the interest rate risk. Plus you have less credit risk than a portfolio with a wide range of maturity dates,” says Cielinski.
In recent months, one of the best-performing sectors in corporate credit has been financial companies. Today, there are reasons emerging to begin looking elsewhere.
“We’re now reducing our lower-rated financial holdings, which performed very well as banks recovered from the financial crisis,” says Paul Read of Invesco Perpetual. With the balance sheets of major financial companies now much improved, bond yields in the sector have already come down. “Our bigger exposures now are to telecoms, financials and food.”
Regardless of where you find opportunities, the starting point for analysis is the same as for any other bond, according to Columbia Threadneedle’s Jim Cielinski. Thus due diligence still means looking at the company’s fundamentals. But another advantage for shorter-maturity bonds is that transparency is much greater. As he says, “It is much easier to check what a firm has in cash, assets and bank lines.”
“At the shorter end of the curve,” Cielinski explains, “the increased balance sheet clarity means you have a better chance of predicting credit stress or defaults. That enables an active manager to do very well.”
Jim Cielinski is a co-manager of the St. James’s Place Strategic Managed fund and Paul Read of Invesco Perpetual is a manager of the St. James’s Place Corporate Bond fund. The opinions expressed are those of Jim Cielinski and Paul Read and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. Full advice should be taken to evaluate the risks, consequences and suitability of any prospective fund or investment. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.
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