A good investment is a function of two variables: price and quality. In the corporate bond world, quality reflects the likelihood of default and is impacted by the corporate’s level of indebtedness and the robustness of its business model.
The expected annual return of a basket of corporate bonds is the average effective yield net of any credit losses arising from defaults. So, in a best-case scenario of no defaults, the maximum upside of a bond portfolio is the yield.
An age-old debate amongst investors is whether price is more important than quality. Luckily, in bonds, because expected returns follow yields so closely, the answer is that price is almost always more important than quality.
The challenge currently is that more than 60% of the fixed income market yields less than 1% and only 2.5% of the market yields more than 4%.
Historical Yield Breakdown of the ICE BofA Global Fixed Income Markets Index
Source: Bloomberg; as of August 2021
This is a far cry from the yields available 20 years ago, and even two years ago. It is not only government bond yields that are very low, but also corporate credit spreads (the difference in yields between government and corporate bonds).
Global Investment Grade Corporate Bond Markets Yield Spread Over Government Bonds
Source: Bloomberg; as of June 2021
With many government bonds and even some corporate bonds being a liability (negative yielding), the challenge investors face today is the greatest in a decade and beyond. Extreme valuations come at a time when fundamentals appear to be rapidly improving as loose monetary and fiscal policies have led to low corporate default rates.
So how can an investor navigate the lowest yielding bond market in recent history?
Step 1: Skip the first four stages of grief straight into acceptance
Those who focus on quality might conclude that we are in a healthy investment environment where investors cannot lose. However, if like us you remember the price side of the equation, you will end up in with the opposite view that markets are dizzyingly expensive.
The first step of navigating an expensive bond market is acceptance – the current investment environment is not paradise, but a paradise of fools.
Step 2: Stay active
The days of passively investing in bonds and doubling your money every 10 years are long gone. That is a mathematical fact.
In our view, however, expensive valuations do not mean that investors should throw in the towel on bonds altogether. First, virtually every asset class prices off bonds, and so valuations are lofty by historical standards across the board.
Second, bonds remain an important diversifier due to their low correlation with equities. Third, the huge depth of the corporate bond universe allows an active investment approach to deliver attractive returns even in difficult valuation environments. In fact, fund selection over the medium term could prove more important than market timing.
Step 3: Be radically reasonable
When asset prices are marching higher, it is all too easy to lower underwriting standards and chase yield. However, we believe that increasing risk appetite when valuations are unattractive is irrational, and therefore would advocate keeping a constant underwriting standard.
This approach leads to a counter-cyclical investing style, i.e., buying aggressively when valuations are attractive and taking a more cautious approach when opportunities are scarce.
It is important to be radically reasonable when others forgo reason. We believe an investor should only buy bonds with a yield that greatly overstates the credit risk, providing a wide margin of safety.
Step 4: Bend as a willow, not an oak
The key advantage of an active strategy is that it is more flexible than a passive one, ensuring that only securities with attractive yields relative to risk are invested in. Flexibility also allows investors to invest throughout the cycle without compromising on credit quality.
Comparing a hypothetical basket of select financial bonds relative to the three largest financial issuers of the Sterling Corporate and Collateralised bond index, which serve as a proxy for a passive investing strategy, the largest issuers in the benchmark, to which passive funds are most exposed to have very high leverage of nearly 20 times their tangible equity.
Even with hugely leveraged balance sheets, these companies produced a very mediocre 4.5% return on equity over the past three years. On the other hand, the companies in the hypothetical basket run a prudent balance sheet (a tenth of the leverage at 2.2 times) and generate attractive return on equity of 10.5%. The hypothetical bond portfolio has robust fundamentals and a yield of 4.4%, nearly three times the benchmark proxy.
Conclusion
In our view, investors should avoid the temptation to increase risk appetite at a point of elevated valuations; and instead adopt a flexible and active approach to navigate the ultra-low-yield environment without taking on undue risk.
Jonathan Golan is a fund manager at Man GLG. The views expressed above are his own and should not be taken as investment advice.