What skinny spreads could mean for corporate bonds

One of the biggest conundrums facing advisers and clients today comes in the form of the Government bond market. In theory a source of steady coupons in return for taking limited risk, this arena is still home to some very scanty yields, even if the negative yields of six to 12 months ago are now just a bad memory (if you go out to ten-year paper and beyond anyway).

With their hand forced by zero-interest rate policies (ZIRP) and Quantitative Easing (QE), income-hunters are being obliged to take more risk than surely they would normally in their quest for dividends from equities and coupons from bonds.

Global Government bond yields are still skinny by historic standards

Source: Thomson Reuters Datastream

This column wishes the very best of luck to those brave souls who snapped up $2.75 billion of June’s 100-year bond from Argentina for its near-8% coupon or this month’s five-year Greek bond that comes with an initial coupon of 4.625%.

After all, Greece’s economy is still in trouble and its finances remain a shambles, with a debt-to-GDP ratio of 179%, a figure which makes even the UK look good.

Moreover, the Financial Times wisely points out that Argentina has five debt defaults on its record over the past 100 years. The odds on more disappointment for its creditors must be high in the next 100, based on that dismal record, so advisers and clients can draw their own conclusions as to whether an 8% coupon on the so-called ‘Century bond’ is adequate compensation for that risk or not.

This may persuade income-hunters to dip their toes into the world of corporate bonds – in theory offering higher returns in exchange for higher risk than Government debt but lower capital upside and lower yields than equities, but with potentially less scope for damage in the form of capital losses.

But even here, credit spreads are narrow and the yield pick-up relative to Government bonds is thin relative to history.

For and against

Now seems a particularly appropriate time to analyse whether corporate bonds may be a suitable asset class for inclusion in a portfolio, for three reasons:

  • First, as outlined above, sovereign debt is offering less and less yield, even if someone, somewhere seems willing to pay for the capital protection theoretically on offer.
  • Second, global inflation expectations are still not running away. The five-year, five-year forward inflation expectation rate in the USA now stands at just 1.98%, dead on the US Federal Reserve’s 2% target. Any corporate bond or fund that provides a yield above this may therefore catch the eye of those advisers and clients looking for some positive real yield in exchange for some capital risk.
  • Inflation expectations continue to sink

    Source: FRED – St. Louis Federal Reserve Database

  • Third, equities may be a potential source of dividend income, with indices such as the FTSE 100 offering a yield of around 4% at the time of writing. Yet the potential for capital loss may deter some risk-averse advisers and clients from getting too heavily involved, especially after an eight-year bull run in developed stock markets.

Equally, there are three good reasons for being cautious:

  • First, corporate bond issuance is rampant. At the end of July American telecoms giant AT&T placed $23 billion in paper with ease. The offer drew $60 billion of bids as the telco carried out the third-biggest bond issue on record. Helped along by such huge deals, US firms alone have raised over $1 trillion in fresh debt in 2017, according to data from Dealogic. If company Chief Financial Officers think it is a good idea to borrow now, because it is cheap, advisers and clients need to ask themselves if it is a good idea to lend.
  • Second, spreads are tight. Research from Bank of America Merrill Lynch shows that the premium highly-rated companies have to pay to borrow relative to the US Government is back to levels not seen since 2014 and before that 2007. This column’s own charts show that the so-called credit spread, between BAA and AAA-rated corporate paper is back to just 68 basis points (0.68%). That compares to a 20-year average of 103 basis points (1.03%) and leaves the spread near the lows seen in 1997 (just before the Asian debt crisis), 1999 (just before the tech bubble), 2005 and 2014.
  • Credit spreads are nearing 20-year lows

    Source: Thomson Reuters Datastream

    In addition, the premium paid by high-yield (junk-rated) borrowers over those with a pristine AA rating is just 173 basis points (1.73%) compared to a 20-year average of 371.

    Junk yield premiums are also nearing 20-year lows

    Source: Thomson Reuters Datastream

    Such low premiums may seem surprising to some advisers and clients, given that the total number of US corporate bankruptcies reached 3,385 in June, well up from the monthly lows of barely 2,000 in late 2015, according to the American Bankruptcy Institute (though at least the figure is nowhere near the 9,000 peak of 2010).

  • Third, central banks are active buyers (for now). One reason why sovereign bond yields are so skinny in the West and corporate bonds so well bid as a result is the European Central Bank’s €60 billion a month Quantitative Easing (QE) scheme. Every month a chunk of this goes into corporate as well as Government debt. In theory, the QE programme comes to an end in December 2017, although President Mario Draghi and his colleagues have left themselves plenty of wiggle room, just in case further monetary stimulus is required. But advisers and clients need to ponder the risk of a ‘taper tantrum’ to match that of 2013 in the US when the Federal Reserve first hinted that it would stop adding to QE. Thin bond yields offer little protection against any capital losses that could ensue.

Multiple options

Perhaps the most bullish thing that can be said about corporate bonds is that the thin credit spreads mean the markets think all is well in the world.

Rising credit spreads are often a sign of risk aversion so it is reassuring to see them rattle lower.

At the same time, the Bank of America Merrill Lynch survey’s reference to spreads being at their lowest since 2007 gives all advisers and clients pause for thought.

Careful research is therefore required before deciding whether corporate debt is suitable for portfolio inclusion, given its risk-reward profile.

For those advisers and clients who decide that the asset class does indeed fit with their overall investment strategy, target returns, time horizon and appetite for risk, there is a good selection of actively-run and passively-managed funds available.

The following tables look at the best performers on a five-year view in the GBP Corporate Bond and Global Corporate Bond categories, though there are alternatives, for those advisers and clients who still feel fixed income has a role to play in a diversified portfolio.

Best performing OEICs in the GBP Corporate Bond category over the last five years

(Where more than one class of fund features only the best performer is listed).
Source: Morningstar, for the GBP Corporate Bond category

There are also nearly 30 investment trusts dedicated to investing in debt, although not all are pure plays on corporate debt. Some specialise in the fledgling area of peer-to-peer lending and this grouping in particular has a limited trading history. The overall yield on the sector of 6.2% suggests that the investment companies as a group lean more toward the riskier end of the lending spectrum.

Top performing debt-specialist investment companies over the last five years

Source: Morningstar, the Association of Investment Companies, for the Sector Specialist: Debt Category

There are also a select number of Exchange-Traded Funds (ETFs) which are designed to track or mirror the performance of baskets of corporate debt securities, and provide their total return, minus the costs of running these passive funds.

Best performing ETFs in the GBP Corporate Bond category over the last five years

(Where more than one class of fund features only the best performer is listed).
Source: Morningstar, for the GBP Corporate Bond category

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.