Corporate bonds: opportunity of a lifetime?
For much of last year corporate bonds were shunned as large, high profile companies collapsed and the global financial system went into meltdown. However, in January, money has poured back into credit markets, attracted by historically high yields (returns) in an environment of volatile equity markets and low deposit rates.
We’ll examine the market and try to help you understand the key risks and opportunities which the markets might currently offer long-term investors.
What is a corporate bond?
The corporate bond market attracted much interest in the first half of this year. You may not be too familiar with this type of investment, but despite sounding quite complex, in reality corporate bonds are just loans to companies.
They’re also known as fixed interest securities because the level of income earned from the interest is fixed in advance. You can invest in them via an ISA or unit trust and the yield (return) is paid back directly to you or can be reinvested.
Asset class of choice
Amidst volatile markets, some investors have sought out the safety of government bonds (similar to corporate bonds, except the money is lent to the government). However, with yields currently at historical lows they offer very little source of potential returns. At the other end of the spectrum, investors are being tempted to dip their toes back into equity markets. This approach, however, will more than likely be coupled with a degree of market volatility and uncertain dividend payments.
At the start of 2009 the most popular choice has been a middle ground between the two: investing in corporate bonds.
The combination of low valuations, a steady yield via interest payments and price volatility that normally lies below what is experienced in equity markets, has led investors back to corporate bonds. Nonetheless, corporate bonds are not without risk.
Investment grade bonds, rated BBB- or higher by credit rating agencies, have a relatively small chance of default (companies declaring themselves bankrupt and therefore stopping bond interest payments) when compared to the sub investment grade bonds, rated BB+ and below by credit rating agencies.
The important question
The most important question is which bonds does the market believe carry the greatest chance of a default and why?
Before the recent crisis, bonds that were trading at very low prices usually did so because there was a fear of short-term default. It’s important to avoid defaults, of course, but as discussed earlier, such events are rare occurrences within an investment grade portfolio. The current weakness of certain bonds is actually more driven by ‘fallen angel risk’ – the risk associated to a bond of it being downgraded from investment grade to sub investment grade.
During the last recession in 2001/02 the proportion of investment grade credits being downgraded to sub investment grade bonds peaked at an annual rate of nearly 15%. This time around it could be higher, but by avoiding these ‘fallen angels’, it is possible for an investor to achieve even greater returns.
The pricing of the corporate bond market suggests that market participants are factoring in increased ‘fallen angel’ risk in certain sectors. In other words, cheap sectors are cheap because there is a high ‘fallen angel’ risk associated with them.
What's the bottom line?
The current corporate bond market has a wide price spread. But the cheap bonds are cheap for a reason, with the coming months looking set to witness an unusually high number of ‘fallen angels’ and the associated reduction in value.
However, the outlook for the corporate bond market as a whole for long-term investors is good by historical standards. With an additional 5% yield over government bonds, an index of investment grade corporate bonds represents an interesting investment opportunity – one which hasn’t been seen since the 1930s.
Furthermore, corporate bond fund managers who successfully buy riskier bonds while maintaining a strict approach to risk management might produce significant excess returns in 2009.
Don’t forget that ISAs, unit trusts and any income paid may fall as well as rise in value and you may not get back the money you invested. Although there is no fixed term, you should consider an ISA as a medium to long-term investment of, ideally, five years or longer.
Unlike ISAs, there are tax implications on any profit you might make from personal income or capital gains with unit trusts. Your tax position depends on your individual circumstances and the tax assumptions we’ve used are those currently relevant. However tax law can change and it may affect you.
Past performance is not a guide to future performance.
The views expressed in this newsletter are those of Legal & General (Portfolio Management Services) Limited and Legal & General Investment Management, who may or may not have acted upon them.
