Corporate bonds face a more challenging environment in 2018; however, even with a supportive macroeconomic and rising interest rate backdrop there are still pockets of value to be found.
On the lookout for jagged rocks
The credit ship sailed through 2017 with modest positive total returns in both the investment grade and high-yield universes. Navigation through 2018 is proving more turbulent, as a volatility spike with an epicentre in equity markets reverberated through to negative returns in credit. Fundamentals are no source for alarm as increasing leverage levels are offset by a healthy macroeconomic environment, yet this backdrop itself is not favourable: rising interest rates and a pickup in inflation are both headwinds for fixed-rate instruments, while spreads over government bonds are historically unattractive. We identify two strategies which in varying ways can benefit from a solid macro environment and allow investors to pick up extra yield versus investment grade and high-yield bonds.
One such source is AA rated sterling-denominated floating-rate asset-backed securities (ABS). These have had negative connotations with investors since the financial crisis. This has been in part due to the complexity of their structure and their (lack of) liquidity, and partly because the regulatory regime implemented in the interim period has imposed punishing capital charges against holding the securities for institutional investors. These factors have led to banks and asset management firms dominating the investor base.
However, the changing market environment makes holding these securities attractive once again. Monetary conditions are supportive: as floating-rate bonds, their coupons will rise in line with interest rates - our economists expect the Bank of England to hike interest rates three times by the end of 2019 - and the securities currently offer an attractive yield versus similarly rated investment-grade corporate and government bonds. A supportive macroeconomic environment also reduces default risk in the underlying securities.
Importantly, behavioural biases against holding ABS are now ebbing. The European Central Bank’s buying of euro-denominated ABS has given the asset class street credibility, and the resulting shortage in supply can encourage investors to switch demand to sterling-denominated assets. The regulatory burden is also under review: the European Securities and Markets Authority is examining securitisation requirements, while in the UK the Financial Conduct Authority is due to make recommendations regarding ABS origination in the auto sector, which we anticipate providing a more favourable report on the practice. These factors are a step in the right direction of reducing the cost of holding ABS on balance sheets.
A supportive macroeconomic environment is also beneficial for assets lower down the capital structure, for which a higher premium must be demanded relative to the risk of holding them. Examining so-called ‘fallen angels’ is one such strategy in this area.
Catching a fallen angel
Fallen angels are bonds within an investment-grade universe that have their credit rating downgraded to high yield status; as a result these bonds are generally excluded from investment-grade indices at the next index rebalance. Due to reasons such as mandate requirements that constrain the holding of non-investment grade securities, and capital charges imposed by regulation on insurance companies holding high-yield bonds, many institutional investors are required to sell these bonds if they are holding them as part of their investment-grade allocation.
Another consequence of central bank policy in the post financial crisis period is that their unconventional bond buying programmes have encouraged corporates to raise funds on the bond market to take advantage of low rates. Thus the size of credit markets has grown, with the value of the investment-grade universe having increased far more than its high-yield counterpart. Following a credit downgrade, the forced selling of fallen angels by institutional investors, as well demand dynamics, can drive the prices of these bonds below their fundamental values, making valuations attractive.
The macroeconomic environment remains supportive for fallen angels as default rates are expected to remain low, although caution is urged in relation to bonds at the lower end of the ratings spectrum as fiscal reform in the US is impacting the ability of companies to deduct interest payments from their tax liabilities. Furthermore, the increasing popularity of fallen angel ETFs will generate a source of buying pressure for these bonds. The behaviour of the individual issuers is also a major factor in supporting bond prices: fallen angels often consist of companies whose objective is to regain investment-grade status by reducing leverage or taking other actions to improve their credit profile, which the market should start to recognise in time (see Chart 1).
Credit forms a vital part of any multi-asset portfolio, with the asset class providing access to riskier securities than government bonds, but also occupying a higher place in the capital structure should macroeconomic conditions deteriorate. In a world where the economic environment is improving, close analysis of certain corporate bonds can provide strategies which offer a yield pick-up relative to their more straightforward counterparts, even when rates rise.