Why corporate bonds look attractive
At the moment corporate bonds look fairly valued in the context of other asset classes
Corporate bond funds have been very popular with investors in recent years, and that is hardly surprising.
Many investors are retired and looking for income. The yield on cash has been close to zero, gilts now yield around 2 per cent and equities have been rather too volatile for many people’s tastes.
However, the higher yield on corporate bonds is of course merely compensation for the increased default risk. So it is worth studying what the default rate has actually been. Jim Reid of Deutsche Bank has just produced his annual study, which looks back over the five years since the start of the financial crisis.
While we have avoided disaster, we have not seen the kind of vigorous recovery that followed most post-war recessions
When Lehman Brothers went bust, many investors were talking about a repeat of the Great Depression and for a while, corporate bonds were priced for such an outcome. But fortunately it didn’t happen. The cumulative default rate on bonds rated Ba, B and Caa or C have been 8.7 per cent, 22.6 per cent and 50.8 per cent respectively. That may sounds like a lot. But the average cumulative default rate (going back to 1970) for these three grades has been 10.1 per cent, 25 per cent and 51.8 per cent. In other words, the last five years have been unexceptional in default terms.
The same is not quite true for the top-rated bonds (Aa and A) which have had slightly above-average default rates (1.1 per cent and 2.1 per cent respectively). But, all in all, this has hardly been the apocalypse markets seemed to be predicting. The sky-high yields of early 2009 were a great opportunity to buy corporate bonds.
The difference between the Great Depression and the crisis of 2008-2009 has been the huge policy response.
Shock and awe tactics in the form of near-zero interest rates, budget deficits and quantitative easing have all been used. This seems to have staved off the bank and corporate collapses that might have occurred – and did occur in the 1930s. If we are to judge the authorities by this criterion, then they have had considerable success.
But what about the position now? While we have avoided disaster, we have not seen the kind of vigorous recovery that followed most post-war recessions. Deutsche Bank points out that the recovery rate – the amount investors get back when default occurs – has not picked up as it normally does. At the moment, it is running at 30 per cent, against the historic average of 40 per cent. In other words, while there may be fewer defaults than normal, the damage caused by each default is greater.
Corporate bond spreads have edged up a bit over the last year (as defaults have started to pick up again) but are still well below their five-year average. Deutsche Bank managing director Jim Reid reckons that, for single B bonds, current yields offer investors a healthy margin over the average historical default premium.