Investors should be wary on the outlook for corporate bonds as the market adjusts to higher interest rates, according to a number of managers who are focusing on higher quality assets.
Although 2018 saw most fixed income sectors post losses as the Federal Reserve continued to hike US interest rates, the new year has seen every Investment Association bond peer group generate a positive average return for their investors.
Sentiment towards bonds has been bolstered by Federal Reserve chair Jerome Powell, who recently suggested that the external factors such as China’s slowdown and a hard Brexit has caused the central bank to pause in its plan to hike interest rates.
Performance of sectors in 2018 and 2019
Source: FE Analytics
But while this U-turn from a hawkish Fed to a dovish one might have benefitted bonds in the short run, Seven Investment Management (7IM) chief strategist Terence Moll warns that interest rates will have to rise at some point – and this means the possibility of a bond catastrophe remains “worryingly high”, particularly to cautious investors who tend to have greater fixed income exposure.
7IM’s investment team has held fewer bonds in recent years in a bid to protect portfolios from this risk, arguing that it is better to give up the 1.1 per cent coupon offered by gilts to avoid a potential 5 per cent capital loss.
“For a long time at 7IM, we have been talking about the impact that rising interest rates will have on portfolios that are heavily weighted to bonds. The maths is simple and inescapable: a 1 per cent rise in the yield of a 10-year bond results in a (roughly) 10 per cent loss of capital,” Moll said.
“For cautious investors, a permanent loss of capital is the key thing to avoid – they have less time and fewer risky assets that can generate gains to compensate. But in seeking to avoid equity market volatility, cautious investors may be taking a far greater unseen risk. Interest rate increases haven’t finished and bonds are still exposed.”
The market had expected the Fed to implement four rate rises in 2019, but this outlook has softened after the dovish statement of its recent Federal Open Market Committee meeting. It has so far taken the Fed more than two years to raise interest rates by 2 per cent and they remain much lower than the long-term average of 5 per cent.
However, Moll pointed out that while interest rates outside of the US remain low, they won’t stay this way forever. Europe is expected to start exiting its negative rate environment in a year or two and Japan is increasingly finding that low rates are unsustainable, the strategist added; there are no major central banks looking to cut rates.
In this environment, 7IM has maintained its underweight position in fixed income. Exposure is taken through quality instruments to reduce volatility and as tail-risk protections, with holdings tending to be high grade government bonds such as gilts, US Treasuries and Japanese and European government debt.
“The global financial crisis wasn’t just about interest rates. The money pumped into global bond markets is in the double-digit trillions. Removing it is not going to be without consequences, no matter how gradual,” Moll concluded.
FOMC ‘dot plot’ for December 2018
Source: Federal Reserve
“Bonds have been in a bull market for the past 35 years, ever since the high interest rates of the early 1980s started to decline. We often hear the comment that ‘interest rates have gone up, and nothing bad has happened to bond markets’. That statement is missing a word – ‘nothing bad has happened to bond markets...yet’. So far, that pain hasn’t happened. But that doesn’t mean the risk has vanished.”
For Man GLG Strategic Bond lead manager Craig Veysey, one of the biggest risks of quantitative tightening centres on BBB-rated corporate bonds. The number of BBB-rated corporate bonds has “exploded” since 2008 as companies used ultra-low interest rates to issue debt then buy back stock and finance other equity-friendly activity.
However, the manager is concerned that large swathes of BBB-rated corporate bonds could fall into the high yield index as volatility rise and worsening fundamentals prompt widespread credit downgrades in this part of the market.
Indeed, the recent Bank of America Merrill Lynch Global Fund Manager Survey found that asset allocators believe corporate balance sheets are overleveraged and believing more action should be taken to de-lever at the expense of cash being used for capital expenditure, dividends and buybacks.
“The suppression of volatility we’ve seen in recent years due to quantitative easing is reversing direction with quantitative tapering likely to amplify volatility. At the same time the economic cycle is not as constructive as it was, with leading indicators weakening in many parts of the world,” Veysey said.
“We are very, very cautious of those cyclical BBB- issuers that lack the flexibility to reduce the size of their balance sheet or increase their cash flow – we think a large number of these could quickly find themselves in the high yield index.”
Due to this, Veysey’s Man GLG Strategic Bond fund has been focusing on defensive opportunities including special situations, particularly where companies are seeking to deleverage, improve their credit quality and avoid shareholder-friendly activity. An example is Tesco, which has been turning around its business and is now only one rating agency upgrade away from moving from sub-investment grade to investment grade.
It’s worth pointing out that not every bond manager agrees that BBB-rated bonds look at risk of being downgraded. Bond specialist TwentyFour recently published a white paper arguing that concerns that there is a wave of downgrades for companies rated BBB could be overdone.
Chris Bowie, manager of the TwentyFour Absolute Return Credit fund, said: “BBBs do have inherent risks, and some are indeed elevated compared to other assets within fixed income. But being actively invested in BBBs can enable an investor to capitalise on their virtues, while avoiding the small subset of BBBs that become ‘fallen angels’ as far as possible.
“The risks are manageable and far outweighed by the benefits, in our view. Our research shows these bonds have consistently produced the very best risk-adjusted returns across the global fixed income market. Avoid them at your peril.”
There have also been warnings that investors should be cautious on the high yield space, despite its strong start to 2019, as the credit cycle matures.
Andrea Iannelli, investment director at Fidelity International, pointed out that high yield credit benefitted from the Fed’s change in stance and rebounding oil prices. Credit spreads tightened by nearly 100 basis points during the past four weeks, undoing the widening seen in December 2018 and taking them back to mid-November levels.
“Looking ahead the performance of the asset class will be driven by the resurging demand for income as the Fed takes a more dovish stance and the performance of oil prices. We are wary, however, that the credit cycle continues to advance, increasing room for idiosyncratic bouts of volatility amid a still challenging market liquidity backdrop,” he concluded.
“The buoyant market conditions have seen some resurgence in bond supply, after December saw little to no issuance coming to market. With plenty of refinancing still pending, a ramp up in supply could become a headwind for returns. From a valuation standpoint, our models indicate that current spread levels still fail to provide appropriate compensation for rising defaults at the lower end of the rating spectrum.
“On balance, we favour a neutral stance towards the asset class, looking for opportunities to increase the average quality of our exposure.”