At the start of 2020, corporate bonds were friendless. The income looked meagre and their capital growth potential limited. High issuance had left a glut of supply, while investors had seen their protections eroded by a new ‘covenant-lite’ approach. How times have changed.
Views formed before the Coronavirus outbreak have quickly become obsolete. Not only has the outlook for the economy, interest rates and corporates fundamentally changed, but the pricing of assets has seen a radical shift. Today, some are suggesting this is ‘best buying opportunity of the century’ for corporate bonds. Asset allocators – even with a wealth of cheap assets to pick from – are driving capital towards the sector.
Fund managers tend to favour their own asset class, but their enthusiasm seems genuine. “Bonds are the bargain of the century – the last time we had this kind of opportunity was in 2009 and I think the opportunity is even better today” says Gregoire Mivelaz, co-manager of GAM Star Credit Opportunities. “Probably the best value investment grade market I have seen in my career,” says Ben Edwards, manager of BlackRock Corporate Bond.
Why so good? Certainly there has been a pretty drastic widening of spreads over government bonds. While the yield on a 10-year treasury has moved below 1% (0.7% at 9th April 2020 – Bloomberg), the average corporate bond has seen its price slide (and yield rise) as investors have worried about corporate defaults.
On the face of it, this looks worrying, a reflection of the pressure many corporates are under, but many believe markets may have gone too far in pricing risk. Darius McDermott, managing director of FundCalibre, says: “Given the threat of a severe global recession, markets have been pricing in unprecedented levels of defaults, but most managers believe the numbers have been over-done and bond assets have been oversold. They also believe the recovery in bond markets will be rewarding.”
“Bond prices have fallen to significantly low levels. As prices have fallen, yields have increased significantly and, for the first time in many years, investors are being compensated for taking extra risk on corporate bonds.”
The Federal Reserve and other central banks have stepped in to start buying corporate bonds, which is helping to support prices. Stephen Snowdon, manager of the Artemis Corporate Bond fund, said: “The initial sell-off was indiscriminate and turned into the worst liquidity crunch in credit markets I’ve seen in my 25 years as an investor.
“But then the new issue market started up, largely thanks to the Federal Reserve announcing it would start buying corporate bonds. We sold some riskier bonds to buy higher quality replacements, and you’d think doing that would involve a big drop in yield – but no. The first two deals came so cheaply we could improve the quality of the fund without dropping too much in credit spread.”
Asset allocators have been moving into higher quality corporate bonds in preference to dividends from shares. Gary Potter, joint head of multi-manager at BMO Global Asset Management says: “We have started to adjust our portfolios into corporate debt. Bonds are contractual, companies have to pay the coupon. Equally, we don’t necessarily want to speculate that equities can rebound when the economic situation in the US is so uncertain. At this level, 6% on corporate debt seems attractive.”
Both McDermott and Potter argue that this is strictly an active asset managers game. There are plenty of sectors – airlines, travel companies, restaurant and pub chains – where the fallout from the virus is not yet clear. There will be horror stories for the unwary. This has been seen in the number of ‘fallen angels’ – companies whose debt has been downgraded as their earnings outlook has shifted – that have hit the high yield market.
McDermott says that active managers can weed out those companies with sufficiently strong balance sheets to be able to survive the next few months, and those that face extreme hardship and possibly bankruptcy. Corporate bond indices, in contrast, will tend to have the highest weighting in the most indebted companies, who may be most vulnerable in this environment.
Potter says: “We’re not buying the index. We’re buying specialist managers that are paying careful attention to quality. There has been a blanket sell-off and it has been possible to pick up high quality corporate debt at lower cost, but there will be some corporates that go to the wall.”