Do corporate bonds still offer value?

Although there has been a strong rally in corporate bonds in recent months, the fundamental outlook for credit hasn’t improved materially. These are testing times; the rate of global growth continues to fade, the Eurozone crisis rumbles on and theUSfaces an impending fiscal cliff. So why have corporate bond markets fared so well recently?

The answer lies in a relentless thirst for yield at a time when interest rates have fallen to ultra low levels. With safe-haven government bond yields at record lows, investors are looking elsewhere for yield, which includes the corporate bond market. It is this excess demand that is now pushing corporate bond yields to historically low levels. The question is whether there is any value left for investors? 

To answer this, we first need to take a closer look at the macroeconomic environment. InEurope, yields on peripheral sovereigns at unsustainable levels prompted ECB President Mario Draghi to respond with Outright Monetary Transactions (OMT). This is a mechanism that will purchase short-dated government bonds from countries that seek bail-out assistance. This will certainly buy time, but it will not solve the fundamental solvency problem presented by unsustainable debt dynamics.

The outlook forGermanyalso appears to be deteriorating; it appears the troubled eurozone periphery is steadily dragging the German economy down from its post-recession bounce. And, in theUS, although there might be signs of a housing recovery, the fiscal cliff threatens automatic government spending cuts across the board at the year-end. These cuts will be indiscriminate and are likely to hurt US and global economic growth. Emerging markets may also no longer be the ‘backstop’ to slowing global growth as they were in recent years.Chinais slowing and there is a risk that it could suffer a hard landing – given that this is the second largest economy in the world, this also does not bode well for global economic growth.

It is not surprising, therefore, that the monetary authorities in the US, the UK and Europe continue to implement aggressive forms of new and untested monetary stimulus; both the US and UK have engaged in successive rounds of quantitative easing, in addition to the ECB’s OMT bond-buying program. However, so far, monetary policy in all its forms has failed to sustainably stimulate real growth in the global economy. The problem is that these developed economies are still deleveraging from their previous excesses and until that process is complete, we are unlikely to see higher levels of sustainable economic growth.

The developed economies face huge levels of debt; not just government debt, but the private debt of companies and households as well. Since the end of the last global recession, debt levels have not fallen quickly enough and this is now proving to be a major drag on economic growth in terms of private sector investment and consumption. Much of the debt from the private sector, post-financial crisis, simply shifted to the public sector; the bank bailouts being a prime example. Unsurprisingly, sovereign ratings have been feeling the pressure. We have already seen both theUSandFrancelose their coveted triple-A ratings and theUKcould follow suit.

For investors, this weak economic environment could pose a threat to the current valuations on corporate bonds. The robust corporate fundamentals that currently support many issuers could dissipate quickly if the global economy takes a material turn for the worse. There is also a tail risk that further aggressive forms of monetary policy, such as quantitative easing, could eventually prove inflationary. So far, the policy has been very supportive of asset prices, suppressing yields on US Treasuries, UK Gilts and German Bunds to all-time lows. There is a risk, however, that yields on these bonds could eventually snap back up towards historical means. Investors would be prudent to reduce duration exposure to limit their portfolio’s sensitivity to interest rate changes.

Returning to the question of whether there is still value left in corporate bonds, I think there is. Spreads are wide by historic standards and they have some room to compress further. However, the bleak macroeconomic environment that I have described is starting to hurt credit quality, which has been slowly deteriorating. This is illustrated by the drift ratio, which has started to fall. The ratio measures the balance between credit rating upgrades and downgrades.

The high yield market paints a similar picture. Default rates are now starting to pick up from their current low levels. However, you would expect this when economic growth falls below 1%. Nevertheless, although I do not think there is much excess value left in the high yield market, investors are still well compensated for rising default rates at current spread levels.

Ultimately, careful credit selection is crucial in this environment. Remaining diversified across sectors and the credit rating spectrum is also important. I believe that investors can still find good upside potential in today’s corporate bond market. It is, however, very important that investors consider the risks they are exposed too when selecting corporate bonds.

By Ian Spreadbury, Portfolio Manager Fidelity Worldwide Investment

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