Fund managers should focus on the sweet spot where investment grade meets high yield for the best opportunities in the bond market, as this is where investors are most likely to get “panicked by a name” and take their eye off fundamentals.
This is according to Richard Woolnough (pictured), manager of the M&G Optimal Income fund.
Speaking at the Bond Vigilantes Forum 2020, Woolnough said he currently sees more opportunities in investment grade bonds than high yield, in contrast to the views of his M&G colleague Richard Ryan, deputy manager of the group’s Charibond Charities Fixed Interest fund.
But where both managers agreed is that the argument is a lot more nuanced than this, with the best opportunities to be found where the two classes merge.
“To me, the segment of the marketplace that currently looks most attractive is actually that crossover world between very weak investment grade and reasonably high-quality high yield,” said Ryan.
“One set of investors is fearful of owning a bond which goes through investment grade to high yield and therefore we’re seeing quite extreme levels of valuation in that BBB- category.
“On the flip-side, the markets have abandoned all hope that we’re going to see ratings upgrades, positive earnings momentum, or any positivity coming out of that and so there’s a growing cohort of companies and issuers that are crossing those boundaries.”
And although Woolnough focuses more on investment grade debt, he likes to hunt towards the lower end of this market. In reality, he said there is little difference between the quality of credits in this area and the top end of the high yield market where Ryan prefers to operate.
“We’re actually just playing in the same field,” the manager explained. “That’s the most interesting area for all of us as bond investors, because that’s the area where people get panicked by a name.
“‘Oh, it’s no longer investment grade’. Well, maybe we never thought it was in the first place. Or maybe it is an index rule that makes people forced sellers. So that is an area where there’s huge potential for excess returns, which is why across all the fixed income floor we work with the analysts to try to identify those particular bonds that have that extra risk premium compared with the market.”
Just as the managers profit from panic when a bond is re-rated from investment grade to high yield, they also aim to take advantage of indiscriminate sell-offs when markets crash and credit spreads spike.
Credit spreads
For example, Woolnough increased his exposure to high yield, long-dated investment grade and US inflation-linked bonds in the first and second quarters of this year as these areas fell out of favour.
Source: M&G
Yet while such a strategy requires a strong stomach, Ryan said it is not as risky as it sounds if you take a selective approach.
“The current crisis really exposed an interesting set of valuations within the marketplace,” he said.
“And there is a whole cohort of companies that are either directly in the eye of this storm or affected by it at the periphery. And our role as investors is not to run from these but to sift through them and see which ones are going to survive.
“Despite being worried about the rise of leverage and underlying corporate fundamentals, it’s not a problem if we look through this type of episode, really hit the balance sheet hard and still see those companies surviving and coming out the other side of it.
“And in those instances, if we get paid to take that risk, then that’s really quite attractive.”
In an article published on Trustnet earlier this year, Woolnough said the coronavirus-related recession would only last three months. Yet while this has proved to be overoptimistic, he still believes that when the pandemic is finally overcome, the recovery will be a powerful one.
“It’s very different from what we’ve had in the past,” he explained. “In the US, disposable income has actually gone up during the recession. Normally it collapses. Normally, people don’t want to spend, but this is very, very different.
“When we come out of it, how the market reacts and how people behave and how the private sector behaves with all this wealth stashed away, it will be very interesting in terms of what kind of rebound we have.
“We have this built-up natural demand to be social animals. And we have built up a natural wealth of cash that has been put to one side.
“So, when we do get out of this – and hopefully the sooner, the better – I think it makes it all very, very different.”
Data from FE Analytics shows M&G Optimal Income has made 127.92 per cent since launch in December 2006, compared with 75.63 per cent from the IA Sterling Strategic Bond sector.
Performance of fund since launch vs sector
Source: FE Analytics
The £2.5bn fund has ongoing charges of 0.84 per cent and is yielding 1.39 per cent.