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October 7, 2011 5:40 pm
Wealth managers are starting to buy investment grade corporate bonds again in the belief that their yields are fully compensating investors for the risks involved.
High-quality bonds from companies with cash on their balance sheets are now yielding significantly more than government bonds, which have seen their prices rise – and yields fall – as investors have sought safe havens in the recent market volatility. The decision by the Bank of England this week to introduce a fresh round of quantitative easing is expected to put further downward pressure on gilt yields.
Some portfolio managers argue that it is now a good time to buy corporate bonds, with debt issued by defensive companies – such as GlaxoSmithKline, National Grid and Vodafone – yielding more than 4 per cent. Spreads – the difference between yields on corporate and government debt – are now 150-200 basis points, as many government bonds yield less than 2 per cent.
David Coombs, head of multi-asset investments at Rathbones, says he is buying corporate bonds for the first time in a year, having sold off all his exposure by August. He is now looking to build his portfolio’s bond allocation back up to 20 per cent, by moving out of cash, in the belief that yields are more than compensating investors for the risks involved.
He believes conditions in the bond market are now similar to those of 2008/2009, when private investors flooded into investment grade debt, believing the market was pricing in too much risk of default.
“What typically happens in a bear market is that the implied default rate is almost always higher than the realised rate,” he explains. “If we go into a 1929-style depression, all bets are off. But I think that’s unlikely – I think we’re going into a shallow recession and some of these companies have reasonable cash flow and will get through it.”
Rothschild Wealth Management has also been buying corporate bonds, arguing that government bonds are “expensive and the fundamentals are poor”.
“In many respects, you could argue there are plenty of companies out there whose balance sheets look a lot more robust than some governments right now,” says Rupert Howard, head of UK portfolio management.
However, spreads have still nearly doubled in some parts of the credit market in the past few months, he says.
“When we look at industrial and consumer companies, we have seen spreads over government bonds widen quite materially since July, which reflects the general risk-off mode we’ve seen in markets. And that implies a default rate that we think is too negative,” he says.
“Corporate bond spreads are trading at close to recessionary levels and starting to offer value,” agrees Adrian Lowcock, senior investment adviser at Bestinvest. He believes non-financial corporate bonds with healthy balance sheets look good value, while pharmaceutical or utility companies with pricing power offer some resilience to poor economic conditions.
Lowcock recommends bond funds such as Axa Global High Income, which has around 60 per cent exposure to the US market, 30 per cent to Europe and the rest in the UK. This fund is mainly focused on high-yield bonds and offers a net income of 5.5 per cent.
Ian Spreadbury, manager of the Fidelity Strategic Bond fund, has just bought a seven-year Imperial Tobacco bond and an 11-year Tesco bond, which give yields of more than 4 per cent – but warns that investors may have already seen the peak in credit fundamentals, and that further improvement in corporate strength will be hampered by weak economies.
Managers say it is therefore important to be selective, with many avoiding corporate bonds issued by financial companies. Coombs is avoiding life assurers, which he thinks are hard to analyse in the current environment, and mainstream European banks.
Even so, Phil Milburn, fixed income manager at Kames Capital, argues that default rates in non-financial companies are likely to be lower than in previous periods of economic contraction.
Lowcock says: “The key is to remain diversified and, in particular, avoid financials, which remain the largest source of volatility in the market since their abilities to operate are threatened by the risk of a eurozone sovereign debt fallout.”
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