What on earth is happening to corporate bonds?

When most investors consider fixed interest investments, they will be thinking about bonds of some kind, whether these be high income, investment grade corporates, or gilts. There is no doubt that the latter two have been in the doldrums over recent years. At the same time, cautious investors could have watched ruefully as equities have left rubber on the tarmac, and low levels of default have made them regard even the racier end of the bond markets as an opportunity missed. Using Financial Express’s Analytics, we can extract a picture of how this has translated into hard numbers over the past three years.

In terms of average sector performance, the returns line up as one would expect, with equities outdoing the riskier bonds, at 63% and 20.3% respectively, and the 9.46% gain in investment-grade bonds trailing behind both. Some compensation should be available in the lower levels of risk associated with bond investments, and indeed both the high yield and corporate bond sectors show volatility of less than half that of the UK All Companies sector average of 7.95%. Counterintuitively, though, it is the so-called ‘junk’ bonds that turn in the lowest measure, at 2.46%, beating corporate bonds’ risk factor of 3.33%.

Of course, these are headline figures that mask a wide range of performance criteria between the individual funds in each sector. By looking at a selection of these in more detail, we can say something about corporate bond funds – since this is our primary concern here - and what’s happened to them.

While the top performer in the IMA’s UK Corporate Bond sector returned 16.8% over three years, there are some dismal results at the other end of the scale, with no compensatory reduction in volatility. This begs the principal question as to whether investors would have been better off placing their money in cash or cash-like deposits with no attendant volatility to worry about. Usefully, Analytics produces a measure called the Sharpe Ratio which helps answer this question in a quantitative manner, while also pulling in the volatility factor.

Sharpe takes a fund’s performance then strips out the benchmark return – on the basis that that would have been generated anyway – and further deducts a notional rate that could have been returned by a risk-free deposit like cash. In our example we are using a rate of 3.5%, although it could be argued that there are better deals around than that. To bring the risk element into the equation, the figure that is left after the two deductions is divided by the fund’s volatility. In this way, we know what return we are getting, over and above benchmark and cash, for each unit of volatility.

In the event, despite relatively low volatility throughout the Corporate Bond sector, only 8 out of 107 funds managed to generate positive Sharpe. Even then the top performer, Old Mutual’s Corporate Bond fund, recorded a figure of just 0.73. It would be charitable to regard this as adequate recompense for taking on volatility at the upper end of the sector’s range, especially when the supposedly riskier ‘junk’ bonds have generated Sharpe ratios as high as 2.8 and volatility measures that are lower. A move into the Other Bond sector, or leaving one’s money on risk-free deposit begin to look the more attractive alternatives. And as Sharpe descends to zero or worse for the other 99 funds, the need to make a decision becomes more compelling.

If this comes too late for investors who have endured the slump in corporate bonds, what of the future? In this, industry views about the future prospects for the sector are polarising. One view has it that the days of cheap credit are over for now, and that bond yields must rise, which indeed they have started to do. Increased interest rates also have their effect on equities, and the 4-year bull market hasn’t got the legs to continue for much longer. So an equities sell-off is in the offing, and this is good news for bonds.

The contrary stance feeds off inflation fears: when inflation is under control, bonds tend to do well, and the converse is the case when inflation is expected to edge up. Another concern is risk: an increasing number of company takeovers are being funded by sub-investment grade debt, and there is plenty of liquidity looking for a place in the current wave of buy-outs. In these conditions the financiers are less insistent on stringent covenants, and the take-over of an investment-grade debt issuer using this kind of leverage degrades the bonds.

In the end, investors in corporate bonds may want to revisit their portfolios, and decide if the diversification benefits are worth holding on to regardless, whether the rosier picture is the more likely, or whether pulling out is better late than never.

1 July 2007