Investors have been piling into corporate bonds as sovereign trades have hit a ceiling and a big squeeze on supply has developed. "Most commentators agree that there is little value left in the EU peripheral debt trade, but the “reach for yield” fix has kept them coming back for more,” said investment strategist Andy Brunner.
He added that there is likely another 25-50bps in spread tightening and the trade must be ‘close to its final act.’ “The argument for corporate bonds is not dissimilar to the EU periphery; as long as things go well there is extra carry and return still to come from holding corporates relative to governments,” he noted.
The big danger however is that this is a bet that nearly all institutional and retail fund managers are taking, Brunner said. While fundamentals still appear sound, with low default rates, it is questionable whether investors are being adequately compensated for their risk, particularly the 'substantial' liquidity risk.
Brunner also noted that corporate bonds are sold ‘over the counter’ in transactions between professionals rather than on an open exchange, which limits the flexibility for investors.
The investment banks that structure and sell corporate bonds have run down stock inventories to low levels and many managers should now be concerned about illiquidity, Brunner said. “From an asset allocation perspective, corporate bonds are perhaps one of the areas of most concern; market participants are hugely overweight an asset where the potential for excess returns has declined significantly and where liquidity is a major issue,” he added.
Gavin Haynes of Whitechurch Securities agreed the corporate bond market is ‘fairly crowed’ so if there is a reason to see a big sell-off then liquidity would be an issue. He added that he expects to see some of the overweight position held by many start to be pegged back in to lower weightings.
Brewin Dolphin’s Ben Gutteridge suggested that while there is a concern it is one that is being overplayed at the moment however. “We are not of the view that the hysteria is entirely merited, we don't think people will sell down high quality corporate bonds,” he said. “We don't see interest rates rising quickly and we continue to see corporate profitability and a resurgence in economic growth toward trend,” he added.
