Is credit still a ‘buy’?

6th October 2010

Corporate bonds was the lowest-selling IMA sector in January this year – suffering outflows that month as well as in February and May – while more flexible Strategic Bond funds have assumed the fixed interest mantle.

With so much of the obvious value in bond markets realised last year, many are now asking whether credit remains a buy.

The bulls v the bears

Sarang Kulkarni, European credit manager at Schroders, likens the situation in bond markets this year to a Mexican standoff between the bulls and the bears and feels it is finally moving towards a showdown.

On one side of the argument – just as in equity markets – bond bulls are encouraged by a solid corporate outlook, with strong company earnings across the board and default rates falling.

Meanwhile, the bears are deterred by the wider macro picture, with indicators such as GDP growth and unemployment painting a far more negative picture of current conditions.

"Bulls remain encouraged credit is in the sweet spot over the medium term, as base rates stay lower for longer, and growth remains subdued but positive – so their case to buy credit and sell government bonds," says Kulkarni.

"On the other hand, the bears believe recovery is not sustainable and developed economies will shrink further, exposing strains in housing and employment and putting additional pressure on already- stretched government finances.

"This means risk assets are not the place to be so their call is to buy government bonds and sell credit."

Bulls gain the upper hand

So far this year, Kulkarni says, excess returns from credit have been positive, so the bulls have had the marginal advantage.

"Current spreads are already signalling a slowdown, with most of the bad news in the price.

"Spreads are very sensitive to GDP, so if a double-dip recession does occur, investors can expect spreads to move materially wider.

"As far as we are concerned however, this is not the base case scenario. We expect, on balance, that the bulls will win out. Against a backdrop of modest, but positive economic growth, we should see spreads tightening further from their current levels."

Gartmore's head of credit John Anderson, is also on the bullish side for credit, favouring BBB-rated debt and so-called crossover names such as William Hill that sit between investment grade and junk status.

"The current dilemma in bond markets lies in the fact credit is priced off gilts, which have done spectacularly well in recent months," he says.

"Government bond yields have fallen to their lowest levels since the war and seem to be pricing in deflation and recession but they are actually only so low in anticipation of a further round of quantitative easing from the government."

For Anderson, consensus is suggesting anaemic but positive growth, which provides a solid background for credit.

"Corporate bonds therefore currently represent decent value on a relative basis, albeit not in absolute terms as they are priced off expensive government paper," he adds.

"But with UK inflation at 3.1% and ten-year gilts yielding 3%, that currently means a negative real yield from this part of the bond market, which is not something I want to own."

Anderson is also cautious on financial debt – an area several managers are currently talking up – after a strong rally since last year.

"If you take tier one Barclays debt for example, it is yielding 8% and offering a 500 basis point premium over gilts," he says.

"Some might see that as great value but tier one debt is quasi-equity and I would say that premium is fair given what banks have been through."

Ben Packenham, who co-runs the high-yield portfolios at Henderson Global Investors, also sees government bond markets as distorted by technical factors, which bleeds into investment grade credit.

He is currently most positive on his own end of the market although admits high-yield spreads imply much worse default rates than expected and overall yields are low.

"Current figures put annualised high-yield default rates at about 0.3% but spreads imply greater market scepticism on some of these companies," says Packenham.

"While there are risks out there, double dips are extremely rare and rapid economic growth is not required for credit to perform well.

"We are relatively positive with defaults low, refinancing markets open and company balance sheets and earnings strong."

He notes interest rates are expected to remain low, pushing investors into higher-yielding assets to meet their income requirements.

"For us, the money flowing into higher-quality debt has pushed the upside potential down so we are continuing to focus on mid-level paper, preferring BBs offering that bit more yield," he adds.

"We also like subordinated financial bonds, with greater clarity for this sector from the recent Basel III proposals on capital requirements for banks."

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