Corporate bonds

Darius McDermott: Is there hope for corporate bonds?

In a weird way, 2020 was the year many bond funds were waiting for. Obviously, there were risks, but after years of scarcity, the opportunities suddenly multiplied – the confectionery was very open for business.

Two years later, it looks like we are back to the status quo of an expensive asset class with few opportunities. Now the volatility is making it even more difficult.

For example, managers of sterling corporate bond funds have had a particularly tough time of late, with the average fund down around 8% in the first few months of this year.

Investors have also become less enthusiastic about the sector, with nearly £800m in net outflows in Q1 2022. companies are likely to be the first assets to be sold. .

But has the combination of geopolitical events and a sharp rise in inflation created opportunities for the sector? There may be some signs that there could be pockets of opportunity along the way.

Will the tapering be as bad as expected?

The first thing I want to address is reduction. As Grace Le, co-manager of Artemis Corporate Bond, points out, this is not the disaster for corporate bonds that many may have thought.

The Bank of England holds around £20bn of corporate bonds (representing 4% of the investment grade sterling universe, which is valued at £500bn, and 7% of the non-investment grade universe). financial).

She says selling the Bank of England’s assets would have an impact, but that would be countered by reducing the risk of pensions.

“We’re seeing companies wanting to shed their pension liabilities and transfer those risks to insurers, who typically sell stocks and buy fixed income securities,” she said.

“It has been a boon to the investment grade market. Last year alone saw around £30bn of de-risking transactions completed. It is estimated that there will be £40bn such transactions in 2022.”

Has inflation peaked?

The other big question concerns inflation – not just its peak, but how low it will eventually drop in the future.

Rathbone Strategic Growth portfolio manager David Coombs said we’ve started to see significant outflows from bond funds, especially liabilities, which often sell with low liquidity. As a result, he took the opportunity to buy credit for the first time in years.

He says: “It’s mainly for the lower-risk funds in the range, as yields of 3.5-4% look quite attractive on our three-year view (where inflation drops to around 3% and rates of interest will have peaked long ago).”

Jerry Wharton, co-manager of SVS Church House Tenax Absolute Return Strategies, said there are now a number of quality bonds issued last year – when yields were low – that are now trading well below the peer.

Examples include the green bond issued by Berkeley Homes last year (proceeds from this issue can only be used to build new homes that qualify for the highest EPC rating).

These bonds are currently trading at 87 (quick reminder that bonds are redeemed at par, 100p) offering a yield to redemption in nine years of over 4%.

Is BBB the sweet spot?

Certain bonds could also benefit from an increase in interest rates, such as the financial companies that come to mind in this scenario.

BBB-rated bonds also have appeal, as they tend to have a shorter duration and are less interest rate sensitive than A-rated bonds, for example.

Exposure to BBBs has increased exponentially in recent years and while the risk exists of being downgraded to high yield, it is important to remember that many of these companies are dependent on access to quality capital markets. superior to finance their commercial activities. As a result, a significant portion of the BBB universe is highly motivated to stay in the investment grade.

BlackRock Corporate Bond fund manager Ben Edwards currently favors this segment of the market, with more than half of his fund allocation in the BBB space.

Increased volatility means patience is the order of the day for investment grade bonds. Investors need to balance the impact of inflation and rising rates, with the solid macro backdrop that should support the corporate bond market.

Much of this will depend on inflation falling, creating medium to long-term yield opportunities, but I expect it to be a bumpy ride.