Should bond investors worry about defaults?
The number of voices predicting a recession are growing. The UK economy contracted in the first...
“Be cautious about corporate bonds in 2020. The margin of safety – or lack of one – means expected returns are low.” Those were the words of Jonathan Golan, fixed income manager at Schroders, at a dinner I attended last week.
Schroders’ 2019 Global Investor Study found that 79% of consumers are investing for a return of 4% or more. Yet, the traditional sources of income – such as government bonds – are no longer sufficient to meet this objective.
The trouble is that, as interest rates remain near record lows, higher-yielding assets are in short supply. For example, at the time of writing, 20% of the global bond market trades at a negative yield, meaning investors that hold those bonds to maturity are guaranteed a loss of capital.
As Jonathan eloquently put it: “If an asset is 100% guaranteed to lose money, it is not only not a safe-haven, it is not even an asset: it has become a liability.”
However, only 14% of the global corporate bond market currently yields 4% or more, compared to a whopping 85% in 1997. Indeed, according to Jonathan, over the past 12 months alone, the yield on corporate bonds has fallen by around 50%.
So what can investors do? Investing in riskier bonds with higher yields is one option.
Being very selective about the bonds in which you invest is another.
Chris Bowie, manager of TwentyFour Corporate Bond fund, which has just celebrated its fifth anniversary, says that: “Looking at the US broad fixed income market over as many discrete five-year periods as I could find data for, you can see that the starting yield accounted for some 90% of the return over the next five years. Given the current yield of global bonds is so low, on the face of it, the next five-year returns look like they also will be low.
“It’s not all doom and gloom, however, as there are two mitigating factors: firstly, over a one-year time frame, virtually anything can happen. 2019 was a good example of that; yields had sold off in 2018 but were still low by historical standards, yet 2019 was one of the best returning years in recent memory.
The second mitigating factor, in our view, is opportunities in sterling credit look disproportionately attractive. The valuation opportunities caused by the Brexit premium are deep (across sector, maturity and ratings band).
“We believe the Brexit premium will be slowly squeezed out of the market over the course of this year, leading to capital gains in sterling credit versus other markets. The best yields can be found in sterling denominated credit, rather than US dollar or euro denominated credit (hedged back to GBP). So we think this is one of the best trades for 2020.
Ben Edwards, manager of BlackRock Corporate Bond fund, says: “When I took over the fund in 2011, bond yields were “low” – the UK government was paying what now seems like a princely sum of 2.5% for its ten year bonds. With 10 year gilt yields hitting a record low of 0.45% last summer, the obvious question for bond managers must be – can we reasonably expect this asset to perform from here? Outside a full-blown recession, we see it as unlikely.
“So we are focussing on the additional returns that high quality corporate bonds can provide. We see valuations of sterling corporate bonds as broadly fair in a historical context and cheap relative to both European and US markets.
“On a sector level, we have long held the view that the nationalisation risk that was priced into UK utility and British Telecom debt during 2019 both overestimated the probability of a Labour election victory and underestimated the time and difficultly that a nationalisation process would face, as well as the relatively positive outcomes for bondholders vs shareholders in these scenarios.
“Since the election, long standing positions in the structurally junior debt of UK water and electrical distribution networks have performed very strongly. BT, too, has contributed strongly to fund performance, as it recovers from the threat of a nationalisation of Openreach and “free broadband for all”.
“While European markets remain broadly expensive there are pockets of incredible value. The burgeoning long-dated euro corporate bond segment (one that has long existed in sterling) is an area we are actively taking advantage off. While continental investors grapple with the novelty of 30-year corporate bonds and how they fit into their traditionally shorter dated portfolios, I smell a bargain!”