He believes that the record low yields seen on corporate bonds still have the scope to go lower. However, he also argues that caution is required in this kind of environment and that careful credit selection, diversification and sound liquidity management is needed.
Is there still value left in corporate bonds?
These concerns are valid, but the recent hysteria around corporate bonds, and in particular market liquidity, is exaggerated in my opinion.
I believe that a conservatively run corporate bond portfolio with prudent liquidity management and access to good credit research offers the best risk-return mix for investors. I also think that corporate bonds continue to play a valuable role within most well-diversified portfolios.
Of course, you may think that as manager of one of the largest funds in the IMA £ Corporate Bond sector, I have a vested interest in taking this stance. I would disagree, however. The position I am in ensures that I constantly think about these issues and the best methods to tackle the current challenging environment.
Do investement grade bonds still offer scope for decent returns?
Yields on investment grade bonds are at record lows. I think investors are right to question how low they can go, regardless of the robust corporate fundamentals that support credit.
My view is that they can go quite a bit lower because the environment of ‘financial repression’ we are in today is likely to continue for some time.
That is because central bankers and politicians remain welded to austerity and ultra loose monetary policy. It’s understandable – they are eager to improve fiscal balances and avoid prolonged economic contraction. It is likely that this will extend the low growth, low inflation and low interest rate environment we see today with significant tail risks attached.
The good news is that low growth and low inflation are both good for corporate bonds – they remain attractively priced versus low yielding gilts – their returns are also less likely to be impaired by inflation.
Yes, corporate credit quality will steadily decline in this type of environment as profit margins erode, but it will decline from a very strong position. Credit ratings may appear more fragile at the margin, but it is worth remembering the historic probability of default for investment grade bonds is still less than 0.2%.
Risks remain, however. On the one hand a more serious economic downturn could see credit spreads blow out; and on the other, quantitative easing could lead to inflationary problems.
Asset allocation can help remove some of this inflationary risk, as can reducing the portfolio’s duration relative to its benchmark. Should we see a serious economic downturn, I believe that corporate bonds would deliver negative returns. Some high quality issuers, however, could actually still outperform gilts and other risky assets.
The UK’s fiscal sustainability could also fall under the spotlight in a serious downturn. Global bond investors make up a third of the gilt market and could demand a significant increase in yield as compensation.
As a consequence, I would expect many sterling-denominated corporate bonds to suffer. Those bonds that are issued from super-solid multinationals could, however, prove a better bet than gilts. Some high quality companies domiciled in Spain and Italy are already issuing bonds with lower yields than their governments – for instance, Telefonica.
That is why names like Johnson & Johnson, Linde and Centrica still have an important part to play in my portfolio despite having sub-3% yields. They provide a solid core in an uncertain macro environment.
I believe it is too early to write-off investment grade corporate bonds because there is still scope for decent single-digit returns in 2013.
I expect the positive flows into the market to continue, although these will be met by falling levels of bond issuance. This demand-supply imbalance may exacerbate an already challenging liquidity environment.
How do you manage liquidity in today’s corproate bond market?
Trading in the sterling corporate bond market is more expensive and difficult than before the financial crisis. These conditions are unlikely to improve any time soon following changes to business models that investment banks follow and the slow progress of new trading platforms.
But, while the average bid-offer spread on sterling corporate bonds has widened significantly, it is important to put this in context with market valuations. Today, the bid-offer spread represents a smaller portion of the total credit spread; less than 5% according to our traders. This means that investors are actually being handsomely compensated for the lower levels of liquidity that we see today.
This is where the importance of good credit research comes in. Every company that I invest in is covered by one of Fidelity’s in-house credit analysts. They not only pore over the company accounts, but also spend time meeting these companies and considering the opinions of Fidelity’s large pool of equity analysts.
That is why I am willing to accept a degree of illiquidity within the conservatively run Fidelity MoneyBuilder Income Fund. This is because I have strong conviction that the corporate bonds I buy are fundamentally sound, based on this rigorous research.
In the event of larger-than-normal redemptions, I am more likely to trim exposure to a broad range of bonds in small deal sizes, and consequently at smaller bid-offer spreads. I believe this is a better option than eliminating the weakest credits that may incur higher trading costs or prove harder to trade.
Broader market events can also impact overall liquidity that can put all funds in the same boat. However, even during the worst of the financial crisis it should not be forgotten that we, like nearly all corporate bond funds, did not have to suspend redemptions to investors.
Portfolio structure is important too. I always ensure the fund is well diversified, generally limiting exposure to any one issuer to no more than 3% of the fund’s assets.
Currently, Lloyds Bank is my largest exposure to an issuer at 3.4%, but much of this is invested in the bank’s triple-A rated covered bonds. The European Investment Bank and UK government are the only other two issuers where the fund has over 3% exposure.
I also ensure that at a sector level the portfolio is not over-exposed to any one particular area of risk. For instance, I have limited exposure to financials, which have proven to be volatile and prone to bouts of illiquidity.
Does the fund’s size make diversification difficult?
I have yet to encounter problems diversifying the portfolio or sticking to new ideas as the Fidelity MoneyBuilder Income Fund continues to grow.
As well as holding sterling issues, I have the scope to invest up to 30% of the fund in non-sterling denominated bonds, where I virtually always hedge away currency risk. I can also access euro or US Dollar-denominated bonds issued by UK-domiciled companies.
Additionally, I can also buy bonds issued by global entities in both currencies; our large credit research team offers me full visibility on these types of opportunities.
I believe it is also prudent to maintain a ‘liquidity buffer’ within the fund. I consider cash, gilts covered bonds and bonds issued by supranationals as readily realisable investments – these consist of around 20% of the Fidelity MoneyBuilder Income Fund.
Clearly, these ‘safer’ bonds will not perform as well as their riskier counterparts during a market rally, but in this high risk environment it also means the fund is not prone to high levels of volatility. Of course, in a strong rally, this conservative approach can lead the fund to underperform against peers. However, over the course of a market cycle, I am confident of better risk-adjusted returns from this type of exposure.
I believe, delivering a consistent incremental return above a comparable market index with a low level of absolute volatility and a decent level of income constitutes successful corporate bond fund management.
In nearly 30 years of investing, I have not known an environment as risky as the one today. Investment grade corporate bonds still play an important part in a well diversified multi-asset portfolio but a cautious approach to credit and liquidity risk management is crucial.
