HUB EXCLUSIVES PANEL DISCUSSION 2022 – CORPORATE BONDS: COMPELLING YIELDS VERSUS IMMINENT RECESSION
Panel discussion, hosted by Cherry Reynard, with:
Adam Darling – Investment Manager, Jupiter Asset Management
Andrew Eve – Investment Specialis, M&G Investments
Simon Prior – Fund Manager, Premier Miton Investors
Corporate bonds have performed better than government bonds in 2022, but only just. Investment grade bonds took a greater hit from rising rates, while high yield performed marginally better as the default rate remained low. Spreads widened out in response to a weakening economic climate. However, 2023 promises to be a very different year.
Simon Prior, fixed income fund manager at Premier Miton Investors says: “It’s been a very difficult year for the asset class. There has been spread and rate volatility. The war in Ukraine has impacted commodities and helped create an energy crisis. We’ve also had quantitative easing finishing, so there has been a net supply of bonds out into the market. In the UK, the Trussonomics impact on LDI strategies was also difficult.” In high yield, he adds, liquidity has been weak, prompting variability in pricing. Spreads have moved out, particularly in Europe.
However, the picture at the start of 2023 is markedly changed. Andrew Eve, investment specialist, fixed income at M&G Investments, says corporate bond valuations look notably more attractive, with yields at the highest levels seen over the last decade. The interest rate adjustment has also had another important impact. Eve says: “Over the past few years, because the risk-free has been so low, a lot of an investor’s return has been coming from the credit spread, so there wasn’t that inbuilt diversification from corporate bonds. Today, they have an element of credit spread and risk free rate, which gives them more diversification.”
Issuance
Slowing issuance may also be a factor. Adam Darling, investment manager, fixed income at Jupiter Asset Management, says that over the past few years, company management teams have been taking advantage of lower yields, which has pushed more bonds onto the market. However, this is already shifting: “Most companies don’t have imminent funding requirements and the number of bonds maturing next year are quite low. On a net basis, 2022 has had lower issuance than previous years. While there have been nuances within countries and sectors, the sterling investment grade market has seen some shrinkage.”
He believes this will continue: companies are having to pay more for any debt they accumulate. They are also going into a weaker economic environment and prioritising the quality of their balance sheets. Data provider Refinitiv reported merger and acquisition activity down from $2.2 trillion in the first half of 2022, to $1.4 trillion in the second – the biggest six month swing since records began in 1980. Warning deal activity will also reduce the need for borrowing.
QT and default risk
Nevertheless, there are potential headwinds. Prior points out that markets still need to process quantitative tightening, as central banks shrink their balance sheets. He says there has been relatively little impact in the UK so far, but there may be a greater impact from the ECB programme. “The ECB has $400bn on its balance sheet, so is a far bigger fish. We expect that to create slightly more ripples in the market. Nevertheless, the Bank of England and Fed should give the ECB confidence that spread movements can be contained.”
Default risk is also likely to rise in the year ahead as the economic environment weakens. Eve says: “We expect to see some slowdown in growth in 2023, which will put pressure on some companies. That means stock selection in individual companies is important. Lots of companies did the right thing in 2021 and refinanced at very low yields. In general, we see relatively few problems in the investment grade market – companies tend to have strong balance sheets.”
He says that the default rates currently implied by market pricing are higher than have been seen historically. “As such, we think, overall, corporate bond investors are well compensated for default risk.” Nevertheless, the credit decision is likely to be increasingly important.
Darling says: “We are focused on lending to a group of high quality businesses. We hope this will be an environment that rewards active managers. A lot of the alpha will come from good credit decisions. We see some good opportunities in the high yield market, but equally, there are some risks. It’s about being selective and patient.”
For him, the areas of caution include consumer discretionary stocks, where earnings are being squeezed by weaker household spending. Property and related businesses could be another difficult area with a big reset in the mortgage market and the cost of capital for institutional investors. Some cyclical industrial businesses are also likely to struggle. Nevertheless, there will be areas of opportunity among companies with defendable earnings, pricing power and strong balance sheets.
With yields at long-term highs, the corporate bond market is likely to be a fertile hunting ground in the year ahead. Nevertheless, a weakening economic environment is likely to raise defaults and careful credit selection will be crucial.
