Corporate bonds bought by the European Central Bank as part of its asset purchase programme are likely to come under pressure as authorities begin to tighten monetary policy, according to M&G Investments Stefan Isaacs.
As such, M&G’s Isaacs is avoiding the bonds in his five FE Crown-rated £1.4bn M&G European Corporate Bond fund.
The European Central Bank (ECB) began to buy corporate bonds under its corporate sector purchase programme (CSPP) as part of its expanded asset purchase programme in June 2016.
Since the start of the programme, the ECB has purchased more than €150bn of corporate debt, with low-rated bonds being among the biggest beneficiaries.
But the authority is calling a halt to its ultra-accommodative policy – ECB purchases of corporate debt totalled a record low of €1.5 billion in August – and is set to wind up its bond-buying programme in December.
Asset Purchase Programme (APP) monthly net purchases
Source: ECB
Isaacs, who has been running the five FE Crown-rated strategy since 2007 said he doesn’t want to own bonds that are distorted by one huge buyer setting the market.
The reason, he said, is that as the ECB winds down its programme, there will be less backing for those bonds, which will lead to some upper pressure on their yields relative to those that haven’t been eligible for the programme.
“Bonds eligible for the ECB programme trade very rich, their yields have been pushed down very aggressively,” Isaacs noted.
“I am not saying that the ECB is going to sell these bonds tomorrow but over time as the ECB winds down we will see some upper pressure on their yields relative to those that haven’t been distorted.”
Isaacs said the team sold out most of their risk in the European peripheric countries including Italy, Portugal or Spain and has exposure to core economies such as Germany, the Netherlands or the UK.
“We sold our risk in the periphery because those bonds had done very well, the yield had come down,” he explained. “The first quarter of the year was clearly a risk-on environment and we felt that we weren’t necessarily being compensated for those risks.
“Italy has seen a significantly repricing there, Italian risks are to the highest of this year so there is more pressure on Italian yields these days.”
Although Italian debt is potentially starting to look interesting again, Isaacs noted that investors remain nervous about the headlines coming out of the country and the potential for a collision between the Italian government and the EU.
“There will be more volatility around Italian assets, we haven’t bought any of the Italian bonds that we owned earlier this year,” said the M&G European Corporate Bond fund manager.
Average yield of Italian government securities at issuance
Source: Dipartimento del Tesoro
Another area the team is favouring is asset-backed securities (ABS), consisting of bonds backed by financial assets. The underlying assets of these pools can be loans, leases, credit card debt, royalties or receivables.
According to Isaacs, although ABS got a bad name during the global financial crisis of 2007-2008 these securities have rarely lost money and continue to look “relatively cheap”.
“We like owning some of those securities,” he explained. “We like the collateral, the fact that you have recourse to a defined set of assets, for instance mortgages or properties, and they pay a floating rate coupon as well, so you are not buying interest-rate risk.”
Another area that is currently offering value is subordinated financials, which they also back in the £97m M&G European High Yield Bond fund he co-manages with James Tomlins.
“Subordinated financials seem to offer good value to us,” said the M&G manager. “The logic there is that banks continue to be very heavily regulated, there is a significant amount of focus on capital, on liquidity.
“When we sit down with M&G’s analysts the message that comes from these guys is: ‘Of course, if the economy falls off a cliff the banking system will be in a tough place but if the economy can continue to grow, then the banking system looks well-capitalised’.
“Generally speaking, we are comfortable lending to the banking sector. We look at valuations and, by historical standards the debt of the historical champions, whether senior or subordinated, looks relatively attractive from a fundamental and a pricing perspective.”
The main challenge, Isaacs noted, continues to be the low level of absolute yield, which makes it difficult to earn a positive real yield without taking a greater amount of risk.
“In Germany, bond yields are negative almost all the way out to the seven or eight-year part of the yield curve,” he said. “Even if you look across economies like France or the Netherlands, et cetera, your yields are similarly negative until you get out to sort of the five-year part of the curve.
“There is no free lunch: in order to earn a positive real return after inflation you have to take risk.”
Isaacs added: “If you contrast that with the US, where if you look at five-year treasuries you do now get a small positive real yield, you realise in Europe you have to go down the risk spectrum to look for a positive real yield.
“In the US, the Federal Reserve has been taking yields higher, the investors have the option of owning relatively short AA-rated treasuries. They have limited amount of risk and they can earn a small positive real yield or a yield of over 2 per cent in nominal terms,” Isaacs explained.
Since launch, the M&G European Corporate Bond fund has delivered a 102.11 per cent total return compared with a 91.55 per cent gain for the average fund in the IA Global Bonds sector.
Performance of fund vs sector since launch
Source: FE Analytics
M&G European Corporate Bond has an ongoing charges figure (OCF) of 0.66 per cent and a yield of 1.51 per cent.