By Richard Woolnough, fund manager at M&G Investments
Bond markets as a whole have expanded considerably in recent decades, reaching a total valuation of around $130trn today and creating a wider and more diverse universe for active managers to take advantage of.
The corporate bond market in particular has seen a dramatic evolution, growing substantially and presenting investors with a huge variety of instruments that didn’t exist 20 years ago.
The investment grade universe is skewed much more towards being heavily BBB-rated – companies took advantage of lower borrowing costs following the global financial crisis to lever up, with little incentive to remain AA- or A-rated.
However, we believe as the cost of borrowing rises, companies will opt to improve their balance sheets. Between 2020 and 2023, there was a net $40bn of ‘rising stars’ (companies upgraded from high yield to investment grade), as companies whose balance sheets were in doubt during the Covid 19 pandemic were upgraded.
In 2023, there were 14 issuers – totalling 45.9% of market value – that were removed from the fallen angel index (an index of bonds previously rated as IG but subsequently downgraded to HY) as they were upgraded back to IG.
We are seeing this in HY as well. Contrasting the HY universe with the IG universe, it is the best quality it has ever been, with data showing that we have never had more BB-rated bonds relative to B- and CCC-rated than we have today.
Dispersion
One result of there being a substantially larger opportunity set is that there is greater scope to take advantage of dispersion in the market, where bonds with the same credit rating trade at different credit spreads over government bonds. Dispersion can provide a rich source of opportunities for active managers to identify mispriced securities.
The expansion in the number of BBB-rated bonds in recent years, as highlighted above, means that there can be significant value opportunities to be uncovered to capture higher spreads while taking the same level of credit risk.
For example, you can buy a security with a 10-year duration and if spreads were to rally 50bps, yields were to come down half a percent, that will deliver a 5% capital return.
Making these decisions can produce some attractive outcomes for fixed income investors. We often think of equities delivering capital upside, while fixed income delivers the yield on the tin, but for active investors with a rigorous credit research team, this does not have to be the case.
Weathering the storm
Looking at default rates in corporate bond markets, markets are pricing in 12% worth of defaults over the next five years for BBB-rated credits – six times more than typically experienced in a five-year cycle and twice the level that was experienced during the global financial crisis.
We don’t anticipate a sharp acceleration in defaults given companies’ financial positions currently and the general macroeconomic environment.
This is because balance sheets of IG firms remain strong in our view. Many companies took advantage of low financing costs during the pandemic to refinance and so benefit from a long maturity runway and the short-term risk of having to refinance at higher rates is diminished.
Inflation can also have positive effects on firms indebted at fixed rates, Put simply, inflation at 5%, for example, for five years, could reduce their debt by a quarter in real terms.
However, going down the rating scale, there are heavily leveraged companies that are more susceptible to defaults and the compensation for risk falls away. This is where a rigorous credit analysis team is essential, both to take advantage of the opportunities and to avoid the pitfalls.
Pockets of value
As ever, for those looking beyond market noise and hunting for value, there are underlying issues and sectors to benefit from; for instance. We are seeing opportunities within certain sectors including European financials.
In our view, European banks are in a positive position today compared to where they have been. We believe there is value, especially within European marketplaces.
We see opportunities particularly within those that struggled with balance sheet issues during the financial crisis and had to deal with bad debts and restructurings, as well as operational restrictions. These have benefitted from a strong tailwind in recent years as rates increased, growing their net interest income (NII), and in turn, generating profits.
A dynamic market
Unlike the equity market, which has essentially stayed static in structure, bond markets have been dynamic, meaning that we are constantly learning as new opportunities present themselves.
As a value investor, markets have proved difficult recently as the opportunity to find mispricing has narrowed. However, after navigating through that tricky period, we now find ourselves back in a situation where fixed income has an attractive entry point, and we can take advantage of dispersion in the markets.
