How can corporate bond investors protect themselves?

Emerging market economic activity has been a little disappointing, but perhaps this reflects the growing pains of much-needed structural reform. The UK is a bright spot, but it needs to diversify away from a housing market boom.

By continuing to provide extremely cheap money, central bankers are doing all they can to encourage corporate chief executives to ‘splash the cash’ and invest in new businesses or create jobs, but you can understand their ongoing nervousness.

In any case, cheap money doesn’t necessarily need to be risked on a new investment that may ultimately fail to make a decent return. Companies can instead use borrowed money to buy back some of their shares. At the extreme, you could raise enough debt to buy back all your stock and go private. If you believe in your current business and bond investors are prepared to offer very low rates of interest, this seems a very sensible option.

From a bondholder’s perspective, this is not good news at all. US fund managers understandably dread reading through the corporate news first thing in the morning in case they find one of their companies has announced a big equity buyback or is being encouraged by activist investors to increase leverage.

And if anything it is getting worse, with Heinz and Dell leveraged buyouts showing that even the biggest names are potential candidates, and the world record $49bn (£30.5bn ) Verizon bond issue in September demonstrating the potential funding available.

Interestingly, the cycle is in different positions across the globe. The US is at the point of prime leveraging activity, with the perfect mixture of economic growth and cheap funding (together with the threat that interest rates could go up, so the window of opportunity might not last forever).

Europe is a little way behind as growth remains too weak for many businesses to convince bondholders that they will be able to generate the returns necessary to pay back the debt.

But with the economy performing better, and with more and more money looking for investments that pay an attractive yield, Europe may only be a year or so behind the US. The UK is somewhere in between, and it wouldn’t be a surprise to see British companies add to debt in the coming months following a decent summer of economic growth.

Given this minefield, how can corporate bond investors protect themselves? A simple answer is that it may be best to invest in those companies that are unable or unwilling to leverage themselves. On the unwilling side, European corporates are still generally in defensive mode. Banks are also looking to deleverage rather than take on more debt.

However, you still need to be careful with the sustainability of the debt they already have, with US banks looking in better shape than many European institutions.

The simplest idea may be to invest in companies that have already undertaken their leveraging activity and are unable to do any more. This can involve funding the companies as they raise debt to pay for their leveraging activity. Or you could just look to the traditional high yield market where many companies have survived with a consistently high level of debt and are not in any position to increase it.

The excess yield that high yield bonds provide investors dwarfs the underlying government bond yield. This means that investors are protected even if central banks start to raise interest rates. The downside is that if the economy takes another turn for the worse, indebted companies may struggle to service their bonds. However, the excess yield still provides investors with a reasonable compensation for such a risk.

Turning the leverage cycle can make investing in strong companies quite a tricky activity for a bond holder. At such times you can feel safer by searching for riskier companies that are unable or unwilling to add to their debt.

But be aware that the final turn of the cycle is when growth disappoints once again, and those with the most leverage struggle to pay it back.

Ben Bennett is credit strategist at Legal & General Investments

BONDHOLDERS WEAKER CAN BE SAFER

Ben Bennett, credit strategist at Legal & General Investments, explains:

“The corporate leverage cycle is accelerating with business leaders increasingly eager to raise debt and return money to their shareholders. Such activity is clearly not good news for bondholders, who may be better off lending money to those companies that cannot afford to lever up.”