Fixed IncomeJul 15 2014

Fears grow of future bond crisis

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Bond managers have voiced fresh fears about buying behaviour in fixed income markets, claiming it could be “sowing [the] seeds for a future crisis”.

Several managers have claimed a rapacious appetite for yield is leading many investors to ignore the downside risks of bonds, purely because of the amount of income they offer over government debt, known as the spread.

Ian Spreadbury, manager of Fidelity’s £3.1bn MoneyBuilder Income fund and the £1.5bn Strategic Bond fund, said there was a “strong consensus” that was overweight in areas such as high yield, subordinated financials, peripheral eurozone debt and hybrids.

“Spreads to government bonds in these credit markets have compressed substantially and are now not far from their tightest ever levels, [which were] mostly set back in 2006/07 just before the financial crisis,” Mr Spreadbury said.

“At that time investors began leveraging their investments to squeeze out additional returns. Like today, low-duration, high-credit risk strategies were also commonplace.

“It is difficult to see that trend returning to the same extent, but the savings glut and low interest rates could have an identical effect – pushing credit spreads beyond their tightest levels, while sowing [the] seeds for a future crisis.”

John Stopford, Investec Asset Management’s co-head of fixed income and currency, agreed investors should be concerned about trends within fixed income.

“Central bank action is distorting the cost of capital and likely leading to misallocation, as the yield on debt increasingly doesn’t cover the risks,” he said.

“We are particularly concerned that more speculative borrowers offer limited returns and plenty of downside risk, and investors are taking little account of a lack of secondary market liquidity, which will make it hard for investors to exit if conditions become less favourable.”

He added: “People should be concerned because investment decisions are all about ensuring investment risks are adequately rewarded.”

Jeremy Wharton, manager of Church House Investment Management’s £128m Investment Grade Fixed Interest fund, said many in the bond market currently had “quite a cavalier approach to credit risk”.

“People are rushing into things they would not have looked at five years ago,” he said.

“There is lots of high yield which is actually not that high in yield. You are not getting compensated for the risks you are being expected to embrace.

“If a high-yield bond is yielding 4.75 per cent, for instance, it is not a high-yield bond. There has been such a reach for yield and it does distort the perception of what they are getting involved in.”

However, Ece Ugurtas, head of specialist fixed income at Barings, argued high-yield fundamentals were “sound” with balance sheets healthy and default rates low.

“Spreads are fair value but still provide attractive carry characteristics,” said Ms Ugurtas.

“We should bear in mind we have seen tighter levels historically. But it is a time to be vigilant and not be aggressive in chasing lower-quality new issuance.”

Because of Mr Spreadbury’s heightened awareness of systemic risk, he said he was concentrating on being overweight corporate bonds to “deliver consistent income”. The manager said his average bond rating in his Strategic Bond fund was BB+, which while yielding low levels were less risky.

He said half the fund was in investment-grade corporate bonds and a third in high yield, although this was at the “end of the range” so was “unlikely to increase much from here”.

“Sector allocations are still generally defensive, with a bias towards consumer staples, transport and utilities,” he said.

“I maintain a moderate exposure to financials, bar-belled between high-quality covered bonds and subordinated bonds. I limit financials to 20 per cent of the fund.”

Mr Stopford added that the quality of recent bond issuance had been “deteriorating with weaker borrowers coming to market and some easing of lending standards”.

This had led him to participate in “limited” new issuance and predominantly just focus on refinancing deals of higher quality names he was “already comfortable with” such as Wind and Ardagh Packaging.