The argument for holding investment grade bond funds is now stronger than it was six months ago, according to specialists at M&G Investments, after the recent sell-off put some parts of the market at “very cheap” valuations.
Investment grade bonds – which is debt issued by companies rated BBB- and above by the major ratings agencies – had a strong start to the year as investors looked for safer havens from the Greek debt crisis. But they later sold off as attention turned to the likely timing of the Federal Reserve’s first interest rate increase.
Up until April, investment grade bond yields were falling; as yields are inversely related to the price of a bond, this shows that they were in demand with investors. However, yields started to rise from then on – showing they were being sold and prices were falling – as investors worried about the impact of a potential US rate rise and the uncertainty in China.
After making a 14.15 per cent total return in sterling terms during 2014, the Barclays US Corporate Investment Grade index was up just 2.83 per cent during 2015’s first three quarters. As the graph below shows, the index fell from its high in April and shed just under 11 per cent by mid-June.
Performance of index over 2015
Source: FE Analytics, bid-to-bid performance with dividends reinvested between 1 Jan 2015 and 30 Sep 2015
Gordon Harding, an investment director on M&G’s fixed income team, says the events of the past six months have added to the case for holding investment grade bonds as a part of a diversified portfolio.
Figures from the Investment Association show there have been net withdrawals from IA Sterling Corporate Bond sector in four of the past six months, with the most recent month covered by the data – August – witnessing some £133m in retail money come out of the sector.
However, Harding said: “I think there’s still a pretty good argument for holding investment grade and more so now than there would have been six months ago. We’ve seen valuations cheapen up quite significantly and there’s been quite a big sell off in credit spreads for some time now – they are now quite a bit wider than they were 18 or so months ago.”
Credit spreads – or the difference between investment grade bonds and government bonds – have widened by around 50 basis points since the European Central Bank launched its quantitative easing programme in March this year, he notes. 
“Essentially, we think that around 50 basis points of extra spread is pretty attractive,” Harding (pictured) said. “We still think we’re getting over-compensated for the risk of default within investment grade bonds as we think the default rate will remain quite low over time.”
Harding highlights the US-dollar investment grade market as one area that is looking “very, very cheap at the moment”. He says credit spreads at the long end of the credit curve – or those that will be redeemed further off in the future – are the widest they have been at any point other than the two major crises of the past 20 years.
“For example, long-dated BBB US investment grade companies are trading at a spread of around 300 basis points over treasuries. That’s an extra 3 per cent over and above the US treasury with a 30-year yield, which is roughly 3 per cent itself – so there’s an all-in yield of around 6 per cent, which is pretty attractive,” he explained.
The M&G fixed income team tends to prefer sterling or dollar investment grade bonds over those issued euros because these two markets have higher government bond yields and wider credit spreads. These two factors make conditions more favourable for investment grade funds.
But Harding says there remain good arguments for owning credit in Europe, especially as spreads have also widened here over recent months. Supportive factors include the effects of QE, which tends to increase demand for bonds and pushes prices higher, and more conservative company management, which avoids getting their firms into too much debt.
The one thing all bond investors are keeping a close eye on, though, is the potential for the Federal Reserve and the Bank of England to start lifting interest rates, as this could prompt a sell-off in the asset class.
“Even though we’re expecting interest rate rises to come through, we don’t think they’ll rise very sharply in the near term. Everyone has been focused on ‘when’ the Fed is going to lift rates; what’s much more important is how long it takes them to get to the peak and where that peak is,” Harding said.
“Our view is that we will see a peak at 2.5 to 3 per cent, so much lower than in previous cycles, which means that the extent of any bear market in fixed income will be less as a result of that.”
“If they do gradually normalise interest rates – as they have been at pains to communicate to the market and we think should happen – there will be some volatility around but I think over the medium term the bond market should be just fine: I don’t think we’ll see a big sell-off as a result.”
He also argues that investment grade bonds have an “in-built balancing mechanism” that helps to protect them from interest rate rises.
While they are sensitive to movements in the government bond yield, corporate bond prices are also influenced by the profitability of the underlying firm; a stronger economic environment that results in rising interest rates is likely to be good for businesses as well.
Harding says that this should not put investors off holding investment grade bond funds that are positioned for this eventuality, adding that the benefits they bring to a portfolio include a diversified income stream and a natural diversifier against an equity sell-off.
However, while he expects investment grade to continue to make positive returns from here, he suggests investors should prepare themselves for more muted gains in the years ahead.
Performance of sector over 8yrs
Source: FE Analytics, bid-to-bid performance with dividends reinvested over 8 years to 30 Sep 2015
“Investors in investment grade have been used to some pretty bumper returns since the credit crisis, double-digit gains in many years,” he said.
“Going forward I think returns are going to be quite a bit lower than that, so we’re talking coupon-clipping rather than generating significant capital returns. However, after the sell-off there’s now scope for some of that capital growth to come back to some extent.”
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