Bonds revisited
Peter Knapton and Richard Macey revisit an asset class where the wider economic issues have masked some real opportunities
KEY POINTS
- Inflation is unlikely to fall below four per cent for now
- Companies issuing corporate bonds are in good shape
- So there is an opportunity here
- Review bank bonds with care
As the debt crisis lurches along, central banks and governments are using every available weapon to encourage sustainable economic recovery. One of the latest measures has been a bond, issued by the European Union, to finance the bail out of Ireland, given that country’s flirtation with complete financial collapse.
Problems with sovereign debt
Should the crisis worsen, the authorities are bound to expand the funds available in the recently formed European Financial Stability Facility.
Where would this money come from? Many of the current measures are already being underwritten ultimately by the German taxpayer. However, if Spain needed bailing out, at a cost of say €200bn, it would be reasonable to assume that Italy would need to contribute its share which would amount to almost 15 per cent of any funding, and this would equate to around two per cent of Italian GDP.1
This further exacerbates Italy’s fragile financial position.
This is not the sort of environment in which to expect strong economic growth. If anything, the large economies of the US, Europe and the UK are likely to carry on muddling through in 2011, with the possibility of a dip back into recession should central authorities withdraw economic stimulus measures too soon.
One of the things we might see is the extension of quantitative easing, namely the printing of money to purchase bonds (and therefore inflate asset prices). History tells us that printing money has always ended in tears – there is little to suggest that things would be different this time.
For more than a year, inflation in the UK has sat around or above three per cent.2 This is far in excess of the Bank of England’s two per cent target and, given the January 2011 VAT increase, higher commodity prices and the relative weakness of sterling, it is difficult to see inflation falling soon. It may well increase in due course.
Opportunities remain in corporate bonds
Despite the wider economic gloom, we believe this economic environment remains supportive for corporate bonds. Both investment grade bonds, namely those with a higher credit rating, from BBB- up to AAA, and high yield, where credit ratings are below BB+.3
Corporate bonds are still priced for a much higher level of defaults than they have experienced historically at this stage of the economic cycle. Spreads on UK, US and European corporate bonds, that is the difference between the income paid – better known as the yield, on a corporate bond and that on a government bond, have been relatively stable in recent months and remain above pre-crisis levels.
Companies that issue corporate bonds remain, in the main, in good shape. Their borrowing costs are low. Their profits improved markedly over 2010, with some firms even setting new profit records. Moreover, many companies have reduced their total debt since the financial crisis began, through downsizing or selling non-core assets. Generally, companies are in good fundamental condition, although of course should an issuer of a bond default on their promises or be perceived as an increased credit risk then the value of an investment will fall.
Additionally, we have seen high quality issuers of corporate bonds take advantage of record low interest rates to extend their debt profile – sometimes by issuing more bonds.
… but less so in bank debt
Bank debt is however a different case. Being a much larger bond universe than non-financial corporate bonds, bank bonds dominate bond indices.
In Ireland, the banking sector is close to collapse and, more generally, it faces a massive challenge to re-finance itself in the private sector. Future regulation is very uncertain with no clarity of the position of bondholders in the case of further ‘restructurings’.
Some bank bondholders are highly likely to suffer ‘haircuts’. This means losses, such as a reduction in credit quality or income. Hitherto, it has been Europe’s taxpayers which have provided funding to prop up failing banks. Now, governments are all too aware that electorates are unwilling to bail out bankers.
However, investors cannot completely ignore banks and must look at their bonds only very selectively, carefully assessing to whom they lend and where in the capital structure they sit. Meticulous analysis has always been of crucial importance here and it is particularly the case today. This includes a top-down review of the economic environment in which a bank operates, assessment of the bank’s ability to raise capital and a sound understanding of the assets and liabilities on a borrower’s balance sheet.
We believe this approach indicates that the list of viable investment opportunities extends to just 20 to 30 of the world’s banks. Even then, investors should look for those bonds that sit higher up a bank’s capital structure because they will be closer to the front of the queue for repayment in the event of a bank default. As always, bond prices can fluctuate and investors may not get back their original investment.
High yield should continue attracting yield hungry investors
The sub investment grade corporate bond market, or high yield as it is better known, has historically provided investors with attractive opportunities. Opportunities continue to present themselves today, however, investors should be mindful that past performance is not a guide to future performance.
High yield means corporate bonds with a credit rating of BB+ and below. This level of rating means the company has a lower likelihood of honouring its repayment obligations than an ‘investment grade’ bond. By way of compensation, investors can receive a much higher rate of income, against the greater risk to their capital.
This year, we believe that better-quality BB and B rated companies could prosper. If the economy delivers its low growth promises, with interest rates remaining at historic lows, then investors can be expected to be enthusiastic about high yield. This support for the asset class should in turn mean opportunities for discerning investors. Of course, interest rate fluctuations may affect the capital value of fixed interest investments within a fund. The capital value is likely to fall when interest rates rise and vice versa.
… who should in turn keep an eye out for inflation-linked corporate bonds
With inflation sitting above the Bank of England two per cent target and possibly set to rise over the longer term, investors should consider their options. The market for inflation-linked corporate bonds could well become deeper and more liquid if investors demand inflation protection and companies issue bonds to satisfy that demand.
Investors should bear in mind a rising rate of inflation will have the effect of reducing the actual value of any gain by an equivalent amount.
A bond-friendly environment
This year it would be reasonable to assume that the more experienced bond investors will do reasonably well, especially if they take overweight positions in corporate bonds. Low but positive growth, mild inflationary pressures and low interest rates all support this thesis. The big risks to this scenario are further crises in the euro zone, the pace of growth slowing down in China or the US Treasury department struggling to find buyers of its debt. Bond prices may fluctuate and an investor may not recoup their original investment.
Annual growth rates
Figure 1 is an example of one of our charities fixed interest common investment fund (CIF) comprising a mix of deposits, UK government bonds (gilts) and other sterling-denominated fixed interest securities. The annual compound growth rate rises from 6.9 per cent over one year, to 10.2 per cent since the fund’s inception in 1976.
1. World Bank, 2009 data
2. www.statistics.gov.uk/cci/ nugget.asp?id=19
3. For further definitions of this asset class, see William Reid’s article ‘Shaken not stirred’ in Caritas, issue 8, July 2008 at: www.charitiesdirect.com/caritas-magazine/shaken-not-stirred-180.html
Author: Richard Macey
Richard Macey is business development manager of charities at M&G Investments.
His primary responsibility is for supporting investment intermediaries who manage charitable assets, including consultants, stockbrokers and IFAs.
Author: Peter Knapton
Peter Knapton is director of charities at M&G Investments and has primary responsibility managing relationships with the 12,000+ UK charities who invest with M&G.
His fund management career spans some 35 years.
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