Outlook 2015: UK corporate bonds
UK corporate bonds could offer a good source of returns for 2015, provided investors are looking in the right places.
In the past five years, the world’s major central banks have been in uncharted waters, and markets have been led into strange new territory.
UK corporate bonds offer a sound investment opportunity due to relative value, structural supports and technical drivers. Investors just need to know where to look.
The extraordinary experiments in monetary policy have led to historically low levels of volatility, markets awash with liquidity, and bond yields which are close to - or even below - zero. With sweeping changes to the policy environment looming in 2015, we still believe that UK corporate bonds offer a sound investment opportunity due to relative value, structural supports and technical drivers. Investors just need to know where to look.
The Federal Reserve (Fed) has now stopped quantitative easing, and the Bank of England (BoE) stopped some time ago. The next natural step in our view – as the environment normalises for these central banks – is for rates to begin to increase. We expect that in both the US and the UK, rates will rise in 2015. However, while the UK economy has been performing very well, there are a number of economic and political headwinds which mean the outlook for UK economic growth is less clear going forward. This is likely to limit the scale and speed of tightening that the BoE can implement, and provides the first of the three key points that we believe will support UK corporate bonds for the coming year.
Duration risk vs. credit risk
Going into 2014 many investors were optimistic about economic growth and worried about rising interest rates. This meant a lot of assets continuing to flow in to short-duration, high yield and strategic bond funds, as well as equity and multi-asset income funds. In the hunt for yield driven by government intervention in financial markets, investors have become comfortable taking on additional corporate credit risk, but less sanguine about interest rate exposure or ‘duration’. This is because default rates (the number of companies defaulting on their debt repayments) have been suppressed by low volatility, whereas interest rate risk has appeared to be more pertinent as the UK economy has continued to improve.
As we have described above, while we believe that the UK’s economic growth will continue in 2015, there are a number of headwinds. These include a General Election, possible “Brexit” risk and slow growth in the eurozone; the UK’s largest trading partner. This is also occurring in an environment where global inflation remains very subdued. This has diminished the relative risk posed to longer-dated bonds, where duration risk is higher but there are fewer ‘tourists’ in the asset class. Therefore, some longer-dated assets are, in our view, underappreciated by investors.
The positive thesis for long-dated UK credit goes beyond the economic drivers. UK pension funds have a lengthy history of buying long-dated corporate bonds. In the past, this demand has been sufficient to significantly compress long-term corporate spreads versus the equivalent medium term assets. The aversion to duration risk over the past 18 months, as well as the UK government’s announced changes to compulsory annuity purchases, has significantly reversed this trend. Yet the technical support offered by pension funds remains intact. From a regulatory perspective, pension funds are still incentivised to use fixed income assets to match liabilities.
Further, both in the US and in Europe, pension funds are underexposed to long-dated credit assets when compared to the UK, and we anticipate similarly sustained long-end demand in these regions. This is important, as there is a usually a strong correlation between fixed income markets when significant events occur. The recent departure of Bill Gross from bond investor PIMCO emphasised how fears over large capital outflows can have a market impact beyond domestic borders. In October, we again saw fears over US corporate duration damage UK valuations; fears which we believe are overblown.
Relative value, and a good hunting ground
This means that the sterling credit market, on a relative basis, looks cheap compared to other regions and Europe in particular. With GDP growth in the eurozone almost entirely absent and dangerously low inflation, highly accommodative monetary policy will remain in place for a very long time. Low growth and low inflation are therefore supportive characteristics for investment grade bonds from a policy perspective. While this latter point has been priced into valuations by the euro market, sterling credit looks better value. Setbacks in fixed income markets in October have only enhanced this relative value.
On a historic basis, yields on corporate bonds remain low, and investors have correctly highlighted that this makes ‘beta’ returns - those generated by broad market participation - challenging to come by. However, by using an innovative theme-based approach to analysing companies and markets, we believe a number of interesting opportunities can be found. As economic and political uncertainties remain into the coming year, we see good opportunities within sterling credit, while the increase in volatility which we are expecting provides a richer environment for generating outperformance through credit selection.