But, in aggregate, corporate bond spreads still look good value, particularly if compared with their historical averages. This is probably partly due to the existence of a 'psychological yield hurdle', whereby even if the yield on government benchmarks goes to zero, investors will still require a minimum 'hurdle yield' on risky corporate bonds.
On the one hand, this means there is less room for further tightening; on the other, it means that if government yields do go up in the next few months corporate bonds should suffer comparatively less. So, with this is mind, how should an investor structure an allocation to bonds in the coming quarter?
My suggestions favour high grade over high yield. Nevertheless, within the high yield arena I would look to react to idiosyncratic stories and events as they arise, rather than allocating a fixed percentage to the asset class. Many high yield companies are likely to tap the primary market in order to refinance their existing loans: the absolute level of yields and the covenant packages will be key in assessing the - relative - value of these companies' new bonds. If the trends we have experienced since the start of the year continue over the next quarter, these new issues will likely perform strongly.
In the high grade space, the sectors I favour most are telecoms and financials. Judging from the recent earnings season the telecoms sector has achieved quite good levels of cash-flow generation and has reduced its net debt/EBITDA ratio accordingly. The ratio of the average spread level over the average leverage is amongst the most compelling in the corporate bond market; my bond picks are British Telecom, Telefonica and Telecom Italia. Many incumbent operators are nonetheless based in – and exposed to – southern European countries, so any reappearance of sovereign risk maybe a drag on their performance.
Financials have recovered much of their underperformance in 2008 and early 2009, but there are still some decent spreads across the subordinated debt spectrum. Now that the agreement over the new capital requirements for banks under Basel III seems has been reached, there will be less uncertainty for the sector.
Moreover almost all the current Tier 1's will no longer be considered as equity and they will need to be replaced - admittedly over the next nine years. Selected longer-duration bank Tier 1's can be attractive, with the possibility of additional upside if Basel III pushes forward the call decision.
Nicola Marinelli is co-fund manager on the MFM Glendevon King Global Bond fund. The views expressed are his own.