Corporate bonds possess significant advantages, particularly over government bonds, that will set them apart as one of this year’s safe-havens.
Factors such as the limited elasticity of their spreads compared to sovereigns, their strong liquidity and consistent operating performance suggest that corporate bonds are likely to offer strong risk-returns despite continuing challenges in the credit markets. In particular, corporate credit in the industrial gas, infrastructure, consumer goods and media sectors is expected to remain resilient, not least because some of these sectors have a strong potential for growth outside the euro-zone.
Sovereign spread volatility
As the eurozone’s troubles continue, so too will the high volatility of European government bonds. Certainly, sovereign debt spreads have started 2012 by emulating the trend seen in the corporate bond market at the close of 2011, with volatility even greater than that of A-rated corporate bonds and comparable with BBB-rated bonds.
So significant has been this increase in sovereign-spread volatility that it has exceeded the volatility of many corporates domiciled within the issuing country.
That said, fears that the recent downgrade of eurozone countries by Standard & Poor’s and Moody’s (nine and six countries respectively) would shape bond spread and volatility trends have proved largely unfounded, as initial reactions suggest that the largely expected downgrades had been priced in by the markets.
Within this context, corporate bonds are likely to continue to offer investors a safe haven, continuing their 2011 performance as the most profitable asset class among euro-denominated bond products (such as sovereign, covered bonds and senior bank debt).
Strong liquidity and issuance
The solidity of corporates’ credit fundamentals and liquidity situation will enable them to cope with the risk of a credit crunch with more confidence than in 2008. Indeed, positive free cash flows are predicted for most corporate issuers in 2012, despite the continuing economic crisis. And reductions in net debt and leverage ratios can also be expected.
Furthermore, our research predicts the supply of primary paper will decline this year to €107bn, compared with €130bn in 2011. This means the net supply of euro corporate bonds is likely to become negative in 2012 for the first time since the single currency was introduced.
And confidence also breeds from recent full order books as well as the strong performance of euro-denominated deals this year.
Corporates in the industrial gas, infrastructure, consumer goods and media sectors are our positive sector views. On the other hand, telecoms and auto manufacturers are unlikely to fare so well, with the latter set to experience deterioration both in margins and in free cash flow generation for all issuers in the sector.
Continuing caution
Yet some reservations about corporate bonds remain, not least in regard to their expensive pricing and the impact of a potential credit crunch on company finances. Therefore, other asset classes worth considering include covered bonds and, perhaps more surprisingly, senior bank debt.
Covered bonds will benefit from the ECB’s Covered Bond Purchase Programme 2 and the European Commission’s guarantee for bank debts meaning they are likely to fare much better than agencies and supranational asset classes.
Meanwhile, senior bank debt has been under-appreciated by investors to the extent that it has been reduced to a minimal weighting in the majority of diversified credit portfolios. As a result, We are overweight senior bank debt, although it is important to bear in mind the sensitivity of bank debt spreads to the spreads of their country of domicile.
Which brings us back to corporate bonds: an asset class that has less sensitivity to sovereign spreads and benefits from issuers’ strong creditworthiness, liquidity and growth opportunities beyond Europe. It is these factors in particular that mark corporates as this year’s safe-haven fixed income asset.
