Current conditions in the sterling investment-grade corporate bond market warrant an approach that is active, pragmatic and risk aware. Those who embrace such a philosophy may discover some attractive alpha opportunities ahead.
As an asset class, corporate bonds have many well-recognised attractions. There are, after all, good reasons why investment-grade credit is a mainstay allocation in many well-diversified portfolios.
One of the primary features of bonds is that they are finite instruments, characterised by a contractual obligation to generate a stream of cashflows. This certainty of cash flow and specified duration typically delivers lower volatility relative to higher beta risk assets such as equities. However, because the cash flows themselves are capped, credit spreads operate in a mean-reverting manner. When the market is excessively bullish, these finite cashflows become too richly valued, and this lays the base for future underperformance.
For investors who are prepared to undertake diligent, fundamental credit research, and to reduce risk exposure into euphoric market conditions, sell-offs can provide attractive opportunities to generate alpha, as and when they materialise.
Lessons from history
Within our investment-grade corporate bond portfolios, 2020 provided a particularly strong example of this philosophy in action. We entered the year defensively positioned, believing that bond valuations were too rich relative to economic fundamentals and that better entry points would subsequently present themselves. Covid-19 was the pin that pricked the bubble, but with investors positioned so bullishly, any economic weakness could have prompted a repricing.
As the coronavirus spread, our research had focused on how the pandemic itself might evolve, and on considering the outlook for issuers that we believed had sold-off excessively in the initial drawdown. Having entered the pandemic with a relatively defensive stance, the subsequent sell-off created opportunities to increase portfolio risk at attractive entry points, even as many of our peers were forced to crystallise losses by selling corporate bond exposure into the credit spread widening.
As the pandemic drew on, an overwhelming sense of fear in the market gave way to euphoria, as investors perceived that health risks from covid-19 were contained, and that, in any event, governments and central banks would continue to provide policy support at levels that might once have been considered unimaginable. To believers in this “free lunch” theory, a recovering economic environment will continue to be combined with emergency settings on fiscal and monetary stimulus indefinitely. Inevitably, this has led credit spreads to tighten to multi-year extremes – and for us to become increasingly concerned about valuations in certain parts of the high-yield and investment-grade credit markets.
We believe it is at such times, when the market narrative becomes so manifestly one-sided, that it is hard to overstate the importance of both a cool head, and of continuing to undertake the detailed valuation work and sell-discipline that is one of the mainstays of our approach. Put another way, history teaches us that in these conditions, across virtually all major asset classes, few things are as mean-reversionary as credit spreads.