Managers of fixed interest funds are buying back into corporate bonds, which they now see as good value – particularly those issued by financial companies.
Yields on investment grade corporate bonds are currently about 7 per cent, far higher than nominal GDP, which they tend to mirror.
“Most bond managers think there’s a golden opportunity in corporate bonds,” says Mark Dampier, research director at Hargreaves Lansdown. “What bond managers want are boring businesses that are quite predictable and that is exactly what financials are going to turn into.”
Fixed interest funds that are overweight in financial bonds include those run by Invesco Perpetual, Aegon and Henderson. Bonds issued by high quality, well-capitalised banks, or those with good prospects – such as Lloyds, Alliance & Leicester and HBOS – are seen as the best buys.
John Pattullo, director of fixed income at Henderson, says: “The entire debate in the corporate-bond sector is how overweight you are in banking bonds.”
This new enthusiasm is being driven by a perception that the market has priced
too much risk into investment grade bonds. At present, prices suggest that market expects 17 per cent of investment grade bonds to default over the next five years.
Pattullo says: “The worst ever five-year cumulative period since 1970 saw 2.3 per cent default. So either it’s financial Armageddon or it’s just too cheap.”
However, some managers believe that, even at current levels, yields are not quite high enough to justify the risk.
Richard Woolnough at M&G has heavily reduced his funds’ exposure to financial bonds in the past year, arguing that credit ratings could continue to deteriorate. Ian Spreadbury at Fidelity International is also underweight in financials.
Woolnough says: “Risk premiums remain high and they’re not at a level yet which makes us want to buy.”
He also sees a danger in oversupply, predicting that banks will still need to raise capital for a while yet, meaning that new issues of bonds will have low prices.
“We still find better value elsewhere in the bond world,” he says. For example, he is buying corporate bonds issued by companies that are not exposed to the housing
market, such as utilities.
David Roberts, head of fixed income at Aegon, says that there are opportunities in corporate bonds across the risk scale, even in traditional “safe haven”, higher-quality issues such as senior debt or lower tier debt. “Even that dull and boring part of the market, low beta, has been quite exciting,” he says.
He has been buying recent issues from Lloyds TSB and ING, both of which are low tier 2 issues, as well as a new issue of senior debt from Goldman Sachs.
Roberts looks for bonds that are undervalued. These can be bonds that are rated too lowly given the outlook for the issuing company. Or they may be bonds that were rated too highly but where the price is already discounting their re-rating too much – Tesco’s bonds, which were downgraded this week, are an example.
“Within most of the banking sector, we believe there is downward rating pressure,” says Roberts. “However, bonds in that area offer huge compensation, in many cases for multi-notch downgrades.”
Lloyds TSB’s senior debt, rated by Moody’s as AAA, is a case in point. Roberts says that, even at this highest level, you can pick up tier 2 debt yielding close to 7 per cent – 2 per cent more than UK gilts.
“Even if Lloyds were downgraded – and we don’t necessarily think it will be – there’s a huge amount of risk premium offered to investors to hold that particular bond. The trick is to try and anticipate to a greater degree than the rest of the market does.”
One concern for corporate bond investors is whether yields are likely to go down. But many managers see current prices and yields as a ‘win/win’ situation.
Pointing to an HBOS bond with a 9.5 per cent yield, Michael Matthews, fixed income fund manager at Invesco Perpetual, says: “You don’t need to see spreads tighten for this to be a good investment. These issues would have been priced at 6.5 per cent just 18 months ago.”
So if yields do narrow, as expected, the bond will become a good investment for capital gains. Until then, investors get the abnormally high yields as income on their investment.
Pattullo predicts yields will start to come down by the end of the year and that “next year will be a pretty stellar one for bond investing”. He believes this year investors should achieve returns of around 7 per cent but, by next year, they could be as high as 14 per cent.