18/01/2007
Corporate Bond Outlook
Investors are concerned about several aspects of the corporate bond market, most notably valuations, relative supply and demand, and the degree of financial engineering taking place. Corporate bond spreads are tight when compared to historical levels, performing very well compared to gilts or other government debt. However, investors are wary of a rise in defaults, which would force corporate bond spreads to widen out. Currently, Moody's global 12 month trailing speculative default rate is 1.7%. While this compares favourably with 1.9% seen at the beginning of 2006, Moody's are forecasting a rate of 2.5% by the end of 2007, as high yield issuers succumb to an unfavourable combination of leverage and slower economic growth. This is still well below the long term average of 4 - 5%. Also worrying is the high level of issuance of new corporate debt. Sterling credit issuance was close to a record £70bn in 2006, compared with £55bn in 2005 and a 10 year average of only £45bn. The emergence of leverage as a tool in financial markets has been important too, most obviously through the ability of companies to finance acquisitions and refinance debt at historically low rates.
It is the case that most of these reasons for being bearish have been around for some time. Hence, our research suggests the prospects for credit markets are still moderately favourable for 2007. As we expected, corporate earnings growth has been robust at this more mature stage of the business cycle, so defaults have been both low and relatively predictable. Another supportive feature of the credit market is that government bond yields remain low. Although inflation pressures have become more apparent in the past year or so, reflecting higher raw material costs and tighter labour markets, bond investors have been reassured that central banks will not shirk when it comes to taking the necessary action to bring inflation back to target. A third positive factor is the relationship between demand from bond investors and supply from corporates, driven by long term trends such as low inflation, historically low market volatility or the changes to pension fund structure. There is every reason to expect these factors to remain in place and continue to support credit markets in the short term.
Looking ahead into 2007-08, the House View forecasts a harder economic landing than is currently being priced in by most investors. Historically, this has caused higher levels of volatility and problems for credit markets. Most testing will likely be the advent of more bond defaults, or even the expectation of worsening defaults. A cluster of investment grade defaults would be worrying news. Any difficulties that emerge in the corporate bond markets would have an impact on associated asset classes. Examples would include reduced leveraged buyout activity and corporate refinancings as the availability of cheap corporate credit reduced. This would restrict flexibility and remove a bid floor from parts of the equity market. Such an eventuality would lead to growth in the popularity of low risk assets, with investors moving back into cash, AAA money market instruments, and gilts.
Our House View still prefers corporate bonds over gilts in the short term, although caution applies further out into 2007 and 2008. Triggers for investors to monitor would be a deterioration in underlying earnings growth, stronger than expected inflation, a sharper than expected rise in default rates, or a cluster of investment grade defaults.
We have maintained our Heavy position in US Treasuries, as we await the effect of Fed rate rises on the US economy. Falling inflation expectations encourage us to maintain our barbell position, with the addition of duration to our portfolios. Relatively benign inflation prospects in Europe, and a continuing slant towards a tightening bias from the ECB in the wake of continued credit and money supply growth, encourage us to hold our Heavy position in European bonds.
Our House View holds a Neutral position on UK gilts, which we expect to lag other government bonds markets through the early course of 2007. Demand for long dated assets remains strong from pension funds and should continue to support our Heavy positions at the long end of the yield curve. Similar pension considerations apply to the UK index linked market, prompting us to increase our overseas index linked bond exposure. In the credit markets, although the immediate outlook is positive for corporate bonds, in the medium term we will look for selective opportunities to increase our weightings in AAA bonds, and reduce our positions in lower quality debt, as opportunities arise.
Andrew Sutherland, Fund Manager of AAA Income and Corporate Bond funds, Standard Life Investments
Published in Money Marketing on 18 January 2007
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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