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Guide to Bonds
InvestmentsMay 21 2020

The outlook for corporate bonds

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The outlook for corporate bonds

Bryn Jones, head of fixed income at Rathbones Unit Trust Management puts its bluntly: “equity income investing is dead this year."

He is referring to the wave of dividend cuts from companies that are staple holdings of equity income funds, such as oil company Royal Dutch Shell, and HSBC bank.

Corporate bonds differ from government bonds because the fixed income investor is lending the money to a company, and the company’s ability to pay is impacted by wider economic conditions, in a way that is not the case with bonds issued by governments. 

The extra economic risk taken by investors is typically rewarded with a much higher income yield than is available from the government bonds.

Demand for bonds expected to increase

Mr Jones believes that demand for corporate bonds will increase because investors unable to get the expected income from equity holdings will switch to corporate bonds.

Bond owners are higher up the capital structure of a company than are equity holders, meaning they get paid first, before any dividends can be paid. 

Central banks have also been buying some corporate bonds in order to assist liquidity in those markets. 

Corporate bonds have different credit ratings, based on what credit ratings agencies believe is the likelihood that the company will repay the money.

Bonds that have a credit rating of up to BBB in the alphabet are deemed to be “investment grade”, while those bonds with a credit rating below tripe-B are classified as High Yield bonds, and coloquially known as junk bonds. 

Nick Wall, bond fund manager at Merian Global Investors says the yields offered on the bonds of relatively lower risk companies are presently quite attractive to him, and so he “doesn’t feel the need to be a hero” by investing in riskier high yield bonds.

Mark Preskett, a portfolio manager at Morningstar says the average default rate, that is companies not paying back the money, among businesses in the investment grade bond market is 0.5 per cent. 

He says: “It is reasonable to think that default rate might rise during the current crisis, but even if it does, I think at the current yield levels, an investor is being compensated for the extra risks they are taking. “ 

Torcail Stewart, bond fund manager at Baillie Gifford says a client needs to be “deep pocketed” and able to cope with volatility to be significantly invested in high yield bonds in the current climate.

At the current yield levels, an investor is being compensated for the extra risks they are taking Mark Preskett, Morningstar

Only the US central bank is presently buying high yield bonds as part of its pandemic response programme, the others are confining themselves to investment grade and government bond assets. 

Economic prospects

Andrew Hardy, co-head of research and portfolio manager at multi-asset fund house Momentum Global Investment Management says corporate bonds are a useful defensive asset as they are presently pricing in a much worse economic scenario than are equities.

He says: “In the event of a stronger than expected and evenly distributed economic recovery over the coming months and years, returns for most stocks should naturally be expected to outpace the equivalent credits from here. 

"However, if the recovery proves weak and fitful, as many expect, then credit may well deliver better risk-adjusted returns from current levels with less downside risk.  We see a lot more bad news having been ‘priced in’ to credit markets already which creates this more asymmetric return profile.  

Implied defaults in credit markets are very high at present.  Even with conservative recovery assumptions, realised defaults over the next five years would have to exceed the worst cumulative default periods in history before investors lost money across most ratings bands, anything less could result in good returns from here. 

"This margin of safety seems to be greatest within higher quality, investment grade bonds at present.”

James Vokins, who runs the Aviva Strategic Bond fund, says a feature of the corporate bond market in the years to come is likely to be that the gap between the better investments and the worse investments will be particularly broad.

He said he does not expect sectors such as commercial property to recover, and so to remain as poor investments in the future. 

Peter Doherty, head of fixed income at Sanlam Investments said central bank bond buying programmes and this is making it harder to find good quality assets. 

His approach has been to try to buy bonds that central banks are not buying.  

Matthew Cady, investment strategist at Brooks Macdonald says the government initiatives to buy investment grade bonds is enough to make him more keen on the asset class, especially relative to high yield bonds. 

He says: “US and other governments have provided substantial fiscal support, such as wage subsidy support in the case of the UK, with the UK government paying the wages of workers for the first time.

"With this level of policy accommodation, the outlook for corporate bonds is more balanced, and we recently raised our outlook for UK and international corporate debt from negative to neutral.

"We would however continue to distinguish between investment grade corporate bonds, which we now favour over government debt within a UK context, and speculative ‘high-yield’ grade debt where we would continue to be more cautious.” 

Andres Sanchez Balcazar, head of global bonds at Pictet Asset Management says he prefers to own US corporate bonds in the current climate, instead of those issued in the Eurozone.

This is because, he says, the European Central Bank has been buying investment grade corporate bonds for many years, and so bond prices are already relatively higher there.