28/05/2007
Corporate Bonds Still In Demand
Sterling corporate bonds continue to trade in a very tight range against gilts – in 2007, the Barclays non-gilt allstocks index yield spread has been between 58 and 62bps over gilts. We would argue that this stability is in line with fundamentals – corporate wellbeing is strong, defaults are low and equity markets are behaving themselves. However it frustrates those investors hungry for yield, who while arguing that spreads or risk premia should be higher, are failing to find suitable alternatives. Ultimately, it is that frustration which is the biggest threat to corporate bonds in the medium term, as lending criteria succumb to greed and need, and any potential problems are smothered in liquidity for the time being.
Government bond yields remain in a historically low range – inflation is not expected to be a problem and markets are supported by the re-exporting of trade and oil surpluses to the major currencies by some of the more exotic Central Banks. For the yield-hungry investor, another problematic participant on global bond markets has been the leveraged investor. If credit spreads are low, and credit conditions stable, then why not increase returns over governments by leveraging up normal credit? The recent emergence of a credit derivatives market has facilitated that by allowing huge volumes to be transacted, away from the problems that finite physical bonds can encounter.
As a result, the un-leveraged domestic investor who is simply looking for income finds himself completely overwhelmed by these two investor categories, which have been very effective in reducing yields and hence returns. Traditional harbingers of doom for credit markets – heightened M&A, shareholder friendly corporate policies, higher interest rates - are just not delivering any good buying opportunities for him. When markets are so dominated by technical factors, frustrated investors can lose sight of fundamentals and allow discipline to slip. This is what happened in the US subprime market; and seems to be what is happening in the leveraged loan market, where the scramble for investments has led to borrowers achieving incredibly light covenant packages.
Of course, until actual problems emerge, the leveraged investor is immune from harm as long as liquidity is widely available, which it is. The recent US subprime example however, while of limited size and impact, does give a hint at the volatility which could materialize as wide scale credit problems emerge and become amplified by leverage. Consequently, defaults and volatility remain two key indicators for credit. As long as they're behaving, any setbacks in credit are buying opportunities. However, should defaults or volatility rise, leverage has the potential to take spreads to record levels very quickly.
Defaults – a widely quoted measure is Moody's Speculative-Grade Default rate, which is currently at 1.5%. Moody's are forecasting 2.4% by end 2007 and 3.4% by April 2008(Moody's May 2007). This compares with an average of 3.8% since 1970.
Moody's - Annual Speculative-Grade Default Rates 1920-2006
Defaults can be thought of as inversely related to global economic activity – a forward looking indicator which can be used as a proxy is the NAPM manufacturing sentiment index in the US, which has data going back to 1948. Recent default peaks in 1970, 1991 and 2001 in the Moody's default series were all accompanied by troughs in the NAPM index – 39.7 in 1970, 39.2 in 1991 and 40.5 in 2001. Currently the index is at 54.7, and has bounced from 50 after falling from a peak of 63.2 in 2003. Things look quite comfortable for the moment but, if the index falls, we would expect credit markets to become more nervous.
Volatility – a key indicator for equity and credit markets is the VIX. This is an average of implied equity volatility calculated over a range of contracts traded by the Chicago Board Options Exchange.
It has typically been between 10 and 45 and currently is near the bottom end of the range – 13. Quite simply, low VIX implies low corporate spreads and well behaved equity markets – and that has been the case for some time. It has resisted potential upsets in 2005(GM) and 2006(Bank of Japan rate rise) – and indeed it can be low for sustained periods, such as 1991-1996. We think that there may be short term blips in 2007 as the Bank of Japan continues to raise rates, as worries escalate about the Chinese stock market, and as the debate continues about how gloomy the US economy actually is. However for a long term meaningful rise in VIX to 25 or higher, we would need to see a fundamental rise in the variability of reporting by corporates. So far, corporates remain in rude health and are generating cash. However annual earnings growth is reducing gradually to zero, and at some point if that continues, things will get much more interesting.
Andrew Sutherland, Fund Manager of AAA Income and Corporate Bond funds, Standard Life Investments
First published in Fund Strategy - Quarterly Market Review, 14 June 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.
Standard Life Investments may record and monitor telephone calls to help improve customer service.
All companies are authorised and regulated in the UK by the Financial Services Authority.
©2008 Standard Life Investments.
RSS Press Articles