The latest Last Word Research has found that investor sentiment towards developed market corporate bonds over the next 12 months jumped in Q2 (see graph below).
Developed market corporate bonds also saw inflows of €4.6bn in May 2020, while flows for developed market government bonds and high yield bonds turned negative (see graph below).
Two managers talked to Expert Investor, offering their thoughts on the drivers behind the positive momentum in the asset class.
Developed market corporate bonds
Q: Why has the interest in buying developed market corporate bonds over the next year increased remarkably in the last quarter? Is this turn in sentiment driven by opportunistic investors who seek to gain from corporates hit by the crisis but which are otherwise healthy?
Colin Finlayson, co-manager at Kames Capital, said:
The biggest driver has been the asset purchase schemes from the major central banks and, in particular, the US Federal Reserve’s decision to buy corporate bonds for the first time. These programmes offered a ‘backstop’ to the market that, in late March, was trading at its cheapest level in over 10 years.
At the same time, corporate bonds looked attractive compared to other alternatives: Government bonds were trading at or close to zero yields, and with dividends from blue chip equities becoming far less certain, the attractiveness of corporate bonds, for those that require income, was clear.
The sell-off in Q1 saw bonds in both good and bad companies fall sharply in value. The key in all of this was to not be tempted into buying companies in ‘eye of the storm’ sectors, whose business models may be most challenged by the impact of the economic collapse, such as retail, leisure, travel.
At this stage, we still do not know how deep the trough in GDP growth will be and, beyond that, it is very difficult to know with any certainty, what any economic recovery will look like. The support being offered by governments and central banks does give a basis for investors to be optimistic about the outlook for corporate bonds, as the scale of their support can help offset much of the economic uncertainty.
Mauro Valle, head of fixed income and lead fund manager at Generali Investments, said:
Investors are attracted by the spreads that corporate bonds offer, as interest rates will stay low for a long period after the decisions taken by central banks as a response to the crisis. The risk reward [ratio] of credit investments is still positive as spread volatility will probably stay low despite the recession, because the market knows that central banks are willing to buy corporate bonds and [that] they are ready to step up their interventions if necessary.
Investors are always looking for opportunities that can reward their investments. But, in this period, a lot of them could be forced to watch the credit space to avoid negative rates, which will remain for a long period. If an investor has a long-term horizon and can bear the risk of higher volatility, investment grade corporate bonds are offering positive yields and can deliver interesting returns in the medium term.
Q: Can you indicate how large the risk versus the opportunity is to buy developed market corporate bonds?
Valle from Generali Investments said:
In terms of outlook, developed market credit with investment grade rating is and remains the asset class of choice, albeit a pause is necessary after the long rally. The primary market continues to offer room for manoeuvring relative value trades, but new issue premia have evaporated over time and investors need to be more selective when picking names.
Sector wise, we prefer to position ourselves in sectors that are exposed to increased government investments, such as construction and capital goods. These sectors are likely to benefit from government stimulus after the covid-19 crisis, and they do not trade as strongly as traditionally defensive sectors, such as utilities and telecom companies.
Finlayson from Kames Capital said:
The risk/reward of buying corporate bonds today remains compelling, even if credit spreads have corrected somewhat from their wides. With risks to the economic outlook still high, this favours investment grade bonds over high yield bonds on a risk-adjusted basis.
The high-yield market is generally more sensitive to the economic cycle and the current yield premium over investment grade credit may not be sufficient in the current environment. With some defensive sectors now trading at relatively tight spreads, the opportunities going forward will be more in financials and some cyclical sectors, although thorough bottom up credit analysis is required before buying almost anything.
Q: Should investors be concerned about the inevitable repricing of debt when the end of quantitative easing comes?
Generali’s Valle said:
For the time being not at all, as corporate investment grade bonds have a stable investor base and continue to be strongly present in real money asset allocations of investors. Rating migration and consequent repricing would be present in most cyclical sectors or segments more exposed to covid-19 like airlines, luxury and travel.
Q: How should investors evaluate the risk of bankruptcies for their investments?
Generali’s Valle continued:
Investment grade bonds and crossover issuers with stable cash flows have very low default risk. On the other hand, there are a lot of fragile high yield issuers who are more sensitive to even a minor downturn in economic activity. We have seen this in the spring with issuers, such as airline companies, auto, capital goods or car rental businesses seeking aid from their governments or other forms of intervention, including recapitalisation from their major shareholders.
Q: Does the shift in sentiment mean that investors are expecting a recovery and no second wave of the virus?
Kames’ Finlayson said:
No, I believe it is more a reflection of the scale of official support being offered to financial markets rather than an expectation of a V-shaped recovery. While the lockdown restrictions across many countries were lifted earlier than expected, giving a boost to sentiment and expectations on GDP, investors would be very complacent indeed to completely dismiss the chance of a second wave of the virus.
Instead, there is now a belief that individual countries are better placed to cope with any resurgence in the virus, with health systems having already been tested by the initial phase of the virus. Along with the support and stimulus being offered by central banks, this means that the likelihood of markets falling to the extent that they did in March is relatively low.
