The fund manager’s view
Bryn Jones, head of fixed income, Rathbones
The outlook for UK corporate bonds has improved. Why, you might ask. The valuations after the sell-off in rates and credit spreads mean the implied probability of defaults in the valuations/pricing of the bonds currently is far worse than anything we have witnessed, even in 2008.
Therefore, this means there is value in these names as default rates have been very low in investment-grade credit and are likely to remain so. Margins in the first half of this year have held up well and, in some cases, have risen. The solvency of the UK insurers has also picked up significantly and positively for credit investors despite the rise in rates.
Banks also continue to improve solvency and have very strong capital ratios. These capital ratios are a far cry from the very weak capital positions the banks were in prior to the global financial crisis of 2008.
Added to this, the fact that yields have now risen significantly, and with many bonds yielding more than 6%, there is a considerable amount of carry protection in these names.
For the first time in over a decade, investors can take out portfolio insurance by buying UK corporate bonds and get paid to do it. Of course, in the short term, rates hikes and rising inflation will keep UK corporate bonds under pressure, but we are starting to like investment-grade credit more and more. At some point, when rates are near peaking, they will become very attractive investments both in nominal and real terms.
The analyst’s view
Juliet Schooling Latter, research director, Fundcalibre
We have disliked corporate bonds for a long time. We felt the market was distorted by quantitative easing and investors were getting low returns for higher risk. Bar a brief spell at the start of the Covid pandemic, opportunities have been few and far between and we’ve tended to steer clear.
This year has been particularly bad for the asset class, with investors sitting on huge losses. They have lost on both the rates and credit side, which is unusual as these two sides balance each other out.
The market now expects UK base rates of 4.4% by May 2023 and investment-grade credit spreads have almost doubled since the start of the year. The result is the asset class is starting to look interesting again. Yields are now over 5% – versus 2.5% 18 months ago – and modified duration is lower, meaning rate risk is lower.
Another positive is that many companies have taken advantage of low rates to lock into cheap debt for a long time. Many companies won’t have refinancing issues for a while.
However, we are still not 100% sure the market is properly pricing the challenges facing the UK economy and we think credit spreads have further to widen.
In summary, we are getting interested in the asset class again but not yet taking the plunge. For now, we favour 10-year US treasuries, which benefit from a strong dollar, are a hedge against recession and have yields above 3%.
The wealth manager’s view
Frédéric Taché, head of fixed income, St James’s Place
We decided several years ago to ensure our fixed-income funds would all have global exposure, in aggregate, from a geographic point of view. The point was to allow our fund managers to exploit opportunities wherever they occur according to market conditions.
It couldn’t be more useful in the current context, where a lot of investors and central banks decide their next move according to the last printed macroeconomic number around inflation. With levels of uncertainty and volatility so high, flexibility is a key element. As a result of recent events, our funds tend to have a significant overweight to the UK corporate bonds universe.
As an example, while a standard investment-grade corporate index will have around 7% exposure to the UK and a standard high-yield index will have around 3% exposure, our most dynamic funds will have double-digit exposure to the UK – with certain funds being as much as 50% exposed.
There are a few factors behind this: the corporate bond universe in the UK offers some fundamentally robust companies within defensive sectors. Some of these companies have the ability to face the high level of inflation that we experience and are currently trading at a very attractive price.
Additionally, UK companies tend to offer a premium to investors. As of 23 September, looking at indices again, UK companies, in aggregate, will offer a premium of around 45 basis points compared with US companies within a standard investment-grade index. This premium will be around 120 basis points in a standard high-yield index.
The fund buyer’s view
Rob Morgan, chief analyst, Charles Stanley
With sterling investment-grade now tempting investors with yields well in excess of 5%, there is certainly good reason to be looking at the asset class. Yet with central bankers in hawkish mood, dangers are still lurking.
Yields could push higher still if inflation remains sticky and monetary conditions are tighter for longer.
Credit downgrades could also be a factor as the economy slows. The wide range of potential outcomes from competing inflationary and deflationary forces makes the outlook particularly tricky right now.
Nonetheless, with the peak of the inflation and interest rate cycle closer at hand, we are minded to add duration to portfolios through government and other high-quality debt. While the latest inflation reading keeps the pressure on the Bank of England Monetary Policy Committee for now, a lower peak inflation rate and expectations of fast deceleration in price increases next year could soon see this ease.
We believe market expectations that the Bank of England will raise its base rate to 4.5% are too aggressive. Thankfully, it is likely that a UK recession will be mild, with high employment, an income boost from tax cuts and a healthy buffer of consumer savings accumulated during the pandemic.
What’s more, an economic slowdown unfolding in China should see the price of key commodities such as oil and industrial metals continue to soften, allowing a shallower trajectory for interest rates. In this context current yields look attractive.
This article first appeared in the October edition of Portfolio Adviser Magazine
