Investment grade corporate bonds still have “more left in the tank” when it comes to their valuations, according to JP Morgan’s Andreas Michalitsianos, although other managers warn that it is best to take a defensive stance in such challenging conditions.
Fixed income markets have performed well this year as low interest rates have pushed investors to move out of cash in the hunt for yield. Market uncertainty caused by growth slowdown concerns at the start of the year and the UK’s shock decision to leave the European Union also saw investors flock to traditionally safer assets such as high-quality fixed income.
However, bond markets rallied further following the Bank of England’s announcement that it would halve interest rates and expand its quantitative easing programme - as well as introduce a £10bn corporate bond-buying facility - last Thursday.
By close of play on ‘Super Thursday’, 10-year gilt yields had fallen to record lows of below 0.7 per cent, which was a 15 basis point fall. The average sterling corporate bond yield also dropped and, according to data from FE Analytics, the IA UK Gilts and IA Sterling Corporate Bond sectors have now delivered more than 57 and 39 times the total return that they did in 2015 on an annualised basis respectively.
Performance of indices in 2016
Source: FE Analytics
Given the strong performance of high quality bonds though, will the Bank of England and the European Central Bank’s bond-buying programmes be enough to bolster the assets over the medium term or should investors consider selling now?
Michalitsianos, who heads up the five crown-rated JPM Sterling Corporate Bond fund, said: “Given the sector’s strong returns so far this year, investors had understandably been asking whether the bid for high quality yield can continue. [Last Thursday’s] supportive expansion of the BoE’s toolkit into corporates, coupled with structurally powerful long-term tailwinds already in place, suggest to us there is indeed more left in the tank in terms of IG credit valuations.”
“We can look to Europe’s recent experience for a sense of where UK IG credit may be heading. The European Central Bank’s staggeringly ambitious corporate bond purchasing programme has had a major influence, with spreads of eligible issuers tightening by approximately 35 per cent since the announcement of the programme in March.”
“If the ECB were to carry on at their current rate for the next three years, they would own as many corporate bonds as all of the retail funds in Europe, so they’re hoovering them up at quite a rapid clip. This major incremental, non-economic buyer is a bullish signal underpinning corporate bond markets.”
The manager adds that there are other factors to take into consideration when looking at the corporate bond sector as we head through the year.
For instance, he points out that central bank policy has led around one-quarter of global bonds to trade on a negative yield, which therefore pushes investors out of government bonds and into corporates to achieve strong returns as well as a higher level of income.
Another reason that Michalitsianos believes corporates will continue to rally is that an increase in M&A activity is likely in the UK, given the current weakness of sterling.
“Historically more M&A meant widening spreads from increased issuance, but today, because of the huge demand, investors are now seeking out liquid issuance driven by M&A. These bonds offer the market both a yield concession to existing securities from the company and liquidity - which has led to strong performance post-issuance of late, and we expect this trend to continue,” he explained.
“As importantly, longer-term trends for IG corporates are also stabilising. Debt growth is starting to stabilise relative to earnings, reducing overall leverage levels, which should help investor sentiment.”
Sterling investment grade growth trends over 5yrs
Source: JP Morgan Asset Management
The manager currently favours European investment grade corporates as they are generally less leveraged than their US counterparts. In terms of sector, he has the highest conviction in utilities, automotives, building materials and banks.
Eric Holt, who runs the five crown-rated Royal London Sterling Extra Yield Bond fund, also favours banks at the moment and has moved to an underweight in supranationals – institutions formed by two or more central governments – because they tend to be low-yielding.
“We’re overweight in subordinated financials. That may seem challenging in some ways but what we believe is it has attractive yields and you’re in a space that, although it’s quite susceptible to sentiment, there is increasing regulation around banks and the requirements for them to have adequate capital to be stress-tested - we saw the results of the recent stress test just a few days back,” he said.
His colleague Paola Binns, senior fund manager and head of the four crown-rated Royal London Sterling Credit fund, adds that all major UK banks passed the recent stress tests initiated by the ECB. While the weakest performer was RBS, she points out that this was due to the large number of fines the firm faces for misconduct.
“Another stress test was applied by an investment bank which shows that, in the worst case scenario following Brexit which is what they would call an acrimonious divorce – so sharp falls in GDP and sharp falls in housing and commercial property and rising unemployment – all the UK banks still have a core tier one ratio of 9 per cent,” she said.
“Although the environment is not good for profitability in terms of capitalisation, we think it’s more than adequate in UK banks.”
That said, the managers believe that a more cautious approach is needed to the asset class given high levels of uncertainty in the market. Binns warns that the biggest headwind the BoE’s corporate bond-buying programme will cause is a further deterioration of liquidity.
Holt also has had a shorter duration across his portfolios than that of their benchmarks, which he admits has hurt his performance year-to-date.
While the manager has outperformed his peer group composite over three and five years, he has underperformed year-to-date by 4.04 percentage points with a total return of 6.77 per cent.
Performance of manager vs peer group composite in 2016
Source: FE Analytics
“We try and manager our clients’ money well over the medium term because I think that’s the best reference point to achieve consistent performance. To be frank that stance won’t have done us any favours to-date. Markets have been strong on geopolitical news and prices have gone up,” he admitted.
“First of all it’s really about diversification so that you’re not in any one specific risk or any particular pot of liquidity.”
“In challenging times with an economy that notably will be slower growing than it otherwise would have been, that orientation towards security with bonds protecting on the downside is a really critical aspect of getting a good balance of risk and returns for our client.”
