Protecting Trustees and Pension Schemes
Following such a stellar performance during 2009, many investors doubted the ability of corporate bonds to post strong total returns again in 2010. However, that is exactly what happened. Now, at the start of 2011, the asset class appears constrained by the dual handicap of low government yields and compressed credit spreads as it faces the headwinds of inflation, peripheral European sovereign risk and an investor base seemingly desperate to re-enter the stock market.
The following article explains why corporate bonds may continue to triumph, despite such adversity.
The past two years have been very good for corporate bond holders. Total returns have been strong across the globe Figure 1, despite initial concerns that 2010 could struggle in the shadow of the exceptional gains of 2009.
We believe that this strong performance should be viewed as a correction of the dire conditions of 2007 and 2008 rather than as a benchmark for future performance. Figure 2 breaks down returns for the global corporate bond index into the underlying return from the performance of government bonds and the excess credit return that comes from taking corporate bond risk (i.e. some extra yield combined with price fluctuations as a result of this corporate risk). In 2007 and 2008, we witnessed large negative credit returns as the market suffered a number of defaults and re-priced corporate bond risk premium. While falling government bond yields mitigated the impact somewhat during 2007, resulting in a positive total return, they failed to do the same in 2008.
Credit risk then reversed direction dramatically in 2009 as corporates recovered from their dire position. Some of this also fed into 2010, but the majority of return during this year was from falling government yields as central banks kept interest rates at extremely low levels and continued quantitative easing programmes to help revive the economy.
As a result of this prolonged recovery, underlying government bonds yields are low and the excess credit yield has compressed significantly from peak levels. From this starting point, how do we expect corporate bonds to fare in 2011 against a backdrop of inflationary concerns, peripheral European sovereign risk and a potential investor shift into equities?
Clearly, very low underlying government bond yields are a concern. Figure 3 shows this compression, plotting yields of various corporate bond indices once the excess credit yield has been stripped out. Given that yields cannot fall much further before they reach zero, it is therefore understandable that investors dwell on the risk of aggressive rate increases from central banks in the face of burgeoning inflation.
However, high inflation is not the only risk to the economy. Indeed, the current low level of government yields reflects the fact that the US continues to pump money into the system to try and reduce historically high unemployment. Also, the Euro-zone is suffering a very mixed growth profile with many countries still struggling to post positive growth numbers. In the UK, the risk of a double-dip recession remains as austerity measures hit home. In other words, deflation remains a possibility for many economies along with associated prolonged low interest rates and even further quantitative easing. As we have seen in Japan during its 'lost decade', it is even possible for government yields to fall further from where they are currently, and remain there for a considerable period of time.
While a further economic slowdown would be good from an underlying government bond point of view, the excess credit yield portion of a corporate bond would suffer. But as Figure 4 demonstrates, even after the contraction of the last two years, excess credit yields remain considerably higher than during the pre-crisis years and more in line with levels seen during the 2001/2002 recession.
This provides investors with a reasonable cushion against economic deterioration going forward. Indeed, should inflation risks materialise and government yields head higher, this excess credit yield again provides a buffer as better economic growth should reduce credit risk premium.
The worst-case economic scenario for corporate bonds is probably 'stagflation', where economic growth remains sluggish even as inflation heads higher. However, it is hard to find any asset class that benefits from such a combination. Corporate bonds would suffer, but they might not significantly underperform government bonds or equities in a stagflation scenario.
A year ago, we believed sovereign credit risk was one of the key "tail risks" for corporate bonds in 2010 – and this remains the case in 2011. Over the past 12 months, we have witnessed the emergency bailing out of Greece, a further banking crisis in Ireland leading to the sovereign asking the European Union for help as well as bouts of significant volatility within the Portuguese, Spanish and even Italian government bond markets.
Within the Eurozone, structural reform and austerity measures are being implemented. However, all of this is being done in the glare of the international bond markets, which can turn off the financing tap at any point, forcing countries to access rescue mechanisms. Of greater concern is that the current mechanisms do not seem large enough yet to cope with the next round of potential funding requirements.
While we would like to believe that European policymakers can finally gain control of the situation, proactively recapitalise struggling banks and provide cheap alternative financing to embattled countries, recent experience suggests that this is unlikely.
The most likely outcome, in our opinion, is that Spain will be forced into funding difficulties before the necessary long-term solutions are agreed. The political willpower probably exists, given that the alternative of a Eurozone breakup would be disastrous. However, even if the final outcome is supportive for financial markets, the period that followed a Spanish funding crisis would be very volatile.
As we proposed in an article in February 2010 (Corporate bonds: 'Beware the tail-risks'), we believe the best way for a corporate bond fund manager to protect their portfolio from peripheral European sovereign risk is to be cautious when it comes to investing in 'captive corporates' from affected countries. These types of companies typically have a large proportion of revenue and profit derived locally or significant assets located in the single country.
In addition, as we saw with the Irish bailout, it is almost impossible to separate the health of the banking system from the sovereign. Indeed, the well publicised interdependency of the European and even global banking systems reinforces the link between bank bond performance and peripheral European sovereign problems.
Therefore while tensions continue to mount, corporate bond managers can use the credit default swap market and buy insurance against the possibility of a portfolio of banks defaulting.
Through careful risk management in the lead up to what could become a Spanish financing crisis, corporate bond investors can reduce the volatility of their investment, while also positioning themselves to benefit if a longer-term solution is eventually found and risk appetite improves.
The final headwind facing corporate bonds is actually a reversal of a theme that supported the asset class during the past couple of years. Fed up with the volatility of the equity market and attracted by historically high corporate bond yields, investors piled into corporate bonds (particularly during 2009), supporting performance despite the fact many corporates were aggressively issuing bonds to address their struggling liquidity positions.
As economic growth prospects are revised higher and as yields rise due to inflation fears, the same investors may be tempted to switch back into equities, potentially reversing this positive support. Indeed, there have been weeks around the turn of the year when retail flows have reflected such an allocation shift. However, the impact should not be overblown.
Many retail investors who have traditionally focused on the equity market will now have had a pleasant experience with corporate bond markets potentially leading them to view this asset class as a fundamental building block for their portfolios in the future. In addition, institutional flows into corporate bonds are likely to remain supportive. Recent equity market volatility has reinvigorated the determination of many pension funds to de-risk and move into bonds where possible. Indeed, as equities rise, thereby closing funding gaps, we expect an ongoing shift into bonds that should dominate any retail outflows.
On the supply side, recent heavy corporate bond issuance should also moderate going forward as companies complete their debt maturity extension and reduce their reliance on bank funding. While the strong supply/demand dynamic may moderate somewhat in the future, it should remain supportive for corporate bonds.
Given the fall in government bond yields and the reduction in excess credit yield, corporate bonds are not as attractively set up for 2011 as they were in 2009 and 2010. That said, while 2011 growth is likely to be robust and inflation is an increasing concern, the global economy still faces a number of hurdles. As the corporate bond market gets back to basics, we expect reasonable upside potential with the added protection of a healthy excess credit yield against risks to growth, inflation and peripheral European sovereign concerns. We expect the asset class to post total returns of 3% to 5% in 2011.
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