In September, the sterling corporate bond sector finally lost its crown as the most popular IMA peer group. By November, flows out of corporate bond funds were gathering momentum and it saw significant redemptions.
Unlike the UK government bond sector, the average fund is still marginally up since the start of the year, but with investors losing faith how long can this last?
There are concerns on the corporate bond sector, but at the top of the list is valuation. The average fund in the IMA Sterling Corporate Bond sector rose by 13 per cent in 2012. The Sterling High Yield Sector generated an even stronger performance, with the average fund up 19.3 per cent.
This has left yields at all-time lows and spreads over inflated government bonds with little room to manoeuvre. If the government bond market starts to collapse – and the UK gilt sector is down by 1.8 per cent since the start of the year – it may take corporate bonds down with it.
Tom Becket, chief investment officer at PSigma Investment Management, says it is vital to re-evaluate the starting yields now on offer in corporate credit and the trade-off between potential returns and the threats of inflation, illiquidity and increasing interest rates.
He says: “With the yields on investment grade bond funds now sub 3 per cent (after charges) and high yield funds typically paying out only 5 per cent to investors, we would suggest that long-term valuations are not sufficient to keep the flow of money into the asset class as powerful as it is now.
“Any signs of a reversal of flows could provide a headache for the swollen behemoth funds that now dominate the sector.”
Which leads to the next problem: liquidity. Richard Woolnough, head of fixed interest at M&G Investments, has said that he does not believe that bond markets are showing signs of a liquidity crisis, many corporate bond managers are reporting poor and worsening liquidity.
Companies have been less willing to take on debt – and have been issuing fewer bonds – and Kames Capital’s Investment Grade Bond fund manager Stephen Snowden has warned that several banks are seeking to reduce their fixed income trading operations. Both elements may put pressure on corporate bond liquidity.
Mr Becket says that even in an ‘income starved’ world continuing to put money into corporate bonds is a strategy with ‘material flaws’. While he recognises that interest rates are likely to stay low for longer, he adds: “Corporate credit is no longer the seemingly ‘one way’ bet it has been in the past few years and we have drastically reduced our exposure.”
John Chatfeild-Roberts, chief investment officer at Jupiter Asset Management, agrees that there is not much value in corporate bonds and investors will probably have to make do with just the coupon payments.
That said, he doesn’t believe that the sector is about to slide imminently: “We believe that we are likely to be in a low-interest-rate environment for some time.
“Although that is a fake situation, it is the reality against which we have to invest.”
He is more worried about the sovereign bond market. He adds: “Sovereign balance sheets look much worse than those of corporates. Sovereigns are spending like fury, whereas corporates tend to be paying down debt.” He is prioritising equities over corporate bonds as a source of income. Where he is still holding fixed income, it tends to be in the strategic bond, high yield or emerging market debt areas.
Mr Becket has opted either for segregated mandates, where he has control over the cash flows and can therefore mitigate liquidity risks, and floating rate notes and asset backed securities, such as those used in the Neuberger Berman Floating Rate Investment Trust.
Corporate bonds no longer look attractive on an income or a capital preservation basis, with fund selectors finding opportunities elsewhere. That said, the market is unlikely to start to turn significantly downwards until there are widespread market expectations of a rise in interest rates. For the time being, with economic data still weak, that seems a long way off.
Cherry Reynard is a freelance journalist
BONDS IN NUMBERS
13% - The average increase of funds in the Sterling Corporate Bond sector in 2012
19.3% - The average increase of funds in the Sterling High Yield sector in 2012
3% - Yields on investment grade bond funds are under pressure
5% - Investors in high yield bond funds can expect this yield
