Appetite remains for high-yield spreads

Corporate bond funds have started to lose their popularity with private investors, according to the latest sales data – but an analysis of the sector’s fundamentals suggests that this shift in sentiment has been premature.

This week, monthly fund inflow figures from the Investment Management Association (IMA) showed that equity funds overtook bond funds, in terms of quarterly net retail sales, for the first time since 2007. Net inflows into equity funds hit £2.4bn in the quarter ending in September, compared to £2.1bn for bonds. As a result, the IMA Sterling Corporate Bond sector fell into second place for monthly sales, having topped the table for the previous 10 consecutive months. UK Absolute Return became the highest-selling sector last month, attracting £442.4m of private investors’ money.

Much of the buying of sterling corporate bond funds has followed a strong recovery in bond prices since the banking crisis of September 2008. In the past 12 months, the FTSE Sterling Corporate Bond Index is up 14.35 per cent, and the index of “AA”-rated bonds, issued by blue-chip companies is up 20.69 per cent. Top performing bond funds have captured all of this rise, and more. M&G’s Strategic Corporate Bond fund was up 25.62 per cent in the year to end September, and New Star Fixed Interest has risen almost 50 per cent since March.

But with these price rises pushing the yields on sterling bonds lower, some analysts believe the best of the returns have been made. “Over the last 12 months, we have seen huge inflows into the corporate bond sector and many investors are now asking whether the best has been had from the sector,” says Peter Day, partner at broker Killik & Co. “My view is that we have seen the best of the returns.”

Andrew Wilson, head of investments at Towry Law, is wary of a sell off. “Investors are chasing returns that have already gone and could equally cause problems should they and other ‘hot’ monies decide to exit all at once. Our sense is that the ‘easy money’ has been made.” S&P Fund Services reported profit taking in its latest review of high yield bond funds.

Analysis of corporate bond spreads tells a different story, though. Spreads – the difference between the yields on corporate bonds and on safer government bonds – widened to record levels after Lehman Brothers collapsed last year. Corporate bond prices fell rapidly in anticipation of widespread defaults by other issuers, pushing the effective yields from bonds’ fixed income payouts up towards double figures. Average spreads on UK and European BBB-rated bonds soared above 500 basis points (ie five percentage points higher than UK gilt yields). When these default fears were not realised, spreads on the UK bonds narrowed to 300 basis points by the end of July, but have not fallen significantly further. They are now not much below the 275 basis point high of 2002 – suggesting that bond prices are not historically high.

“Corporate bond spreads over government bonds do not appear to be overbought compared to previous spread levels going back to the early 1990s,” says Wilson.

Liontrust’s head of fixed income, Simon Thorp, also points to history. “Even though they rallied enormously, investment grade corporate bond spreads are not much different to 2001 and 2002 – so on a spread view there appears value.”

M&G’s head of retail fixed income, Jim Leaviss, concludes that these fundamentals point to further price rises. “Although spreads have tightened in all areas of the market, they have tightened to levels consistent only with a typical recession. They remain wide in a historical context and are still compensating investors for the risk of default.”

An imbalance between demand and supply is already underpinning prices. Fund flow data from the Skandia and Cofunds platforms shows investors moving out of cash and seeking higher returns. “There is a continued technical play in investment grade bonds’ favour,” says Thorp. “Demand, as money comes out of money market accounts looking for coupons, and less supply in the last nine months.”

He forecasts that total returns from corporate bonds will be lower in future, but still 11-12 per cent.