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Bonds ‘euphoria’ makes fixed income markets riskier, says bond manager

19 June 2024

More bonds on the market means limited performance potential going forward.

By Matteo Anelli,

Senior reporter, Trustnet

There is an “extraordinary” new wave of bonds coming to the market and investors are lapping it up, but this bond “euphoria” might come with a hefty price tag in the form of higher risks. That’s according to Christian Hantel, manager of the $919m Vontobel Global Corporate Bond fund.

Fixed income managers have been taken by surprise by the current levels of bond supply. With interest rates as high as they are today, it's costly for corporates to issue new bonds, as they need to reward investors more than when money was cheaper.

However, companies are just going on with their funding, seemingly not caring how they will repay the ­debt, said the manager. Still, this issuance is being taken up “quite well” by investors, who have continued to increment their fixed income allocation.

To some extent, this leaves companies in a riskier position going forward both from a fundamentals and a valuation perspective, Hantel explained.

“As a bond portfolio manager, you need to be sure that you always buy the right risks. This means companies that you know well and are on a good trajectory, be it through stable or improving credit metrics. When new companies come to market, you need to first get familiar with them and how they treat bondholders. That's the first challenge,” he said.

“The second challenge is with the pricing. When there's so many bonds coming to market and demand is so strong, they tend to be priced at the very low end of the of the range, leaving very little extra spread and limiting the performance potential in the corporate bond portfolio”.

This phenomenon is typical for when there's too much euphoria in the market, the manager said, which is the case now even more than it was earlier in the year.

At the beginning of 2024, investors were piling into the fixed income market and appeared willing to buy almost irrespective of price. But back then, premiums were higher, whereas now they have been dropping, which is having a negative impact on future returns.

“During recent bond issuance price talks, institutional investors have been pulling their orders out of the book more frequently because they think it is not creating value,” Hantel said.

“This gives a message to the syndicate teams that the deals are coming too tight and we won’t participate anymore. As institutional investors, we must avoid buying securities that will underperform after launch, so we pay a lot of attention to these dynamics and use discipline by setting a spread limit.”

On a positive note, corporates are using the proceeds of their funding quite conservatively. In Europe, for instance, there aren’t too many mergers and acquisitions or leveraged transactions, the manager explained.

In fact, the bonds that come to market are being used for refinancing maturing bonds and general corporate purposes, such as funding their capital expenditure needs and investments.

One of the questions worth asking is how long demand will stay this elevated and what could go wrong from here on. It’s a difficult prediction to make, but disruption could come in different forms, said the manager.

Firstly, demand could wane in response of an unpredictable macro event, say for example further tension in the Middle East, which could have an impact on risk appetite.

A second option is higher volatility in fixed income markets from uncertain monetary policies – especially if the divergence between the Federal Reserve and the European Central Bank should exacerbate, or if inflation surprises again to the upside – although this is not the base case.

“Whatever the catalyst might be, it's already remarkable that corporate bond spreads have not been impacted by uncertainty or volatility so far,” the manager concluded.

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