Swip's Neil Murray on corporate bond outlook

3 August 2009

Neil Murray joined Scottish Widows Investment Partnership (Swip) in 2000 after spending two years working in investment risk control for Scottish Widows. He is the group's head of credit and runs several investment grade corporate bond portfolios.

Q: What do you think are the key issues facing bond markets at the moment?

A: It really depends on the individual markets. The main driver of the gilt market is that we are coming to the end of quantitative easing, and what the market’s view is on that. People expect that these support mechanisms are coming to a close. Then that moves onto supply and the poor state of fiscal balances. One thing people thought would come to fruition sooner is inflation – stimulus packages in place in the UK and US and what they will do for future inflation and deflation. You still have yields at relatively low levels but the shine has come off the gilt market. Total returns on both the US Treasury market and gilt markets have dropped a few percent.

The demand for corporate bond assets has been extremely strong all through this year, although we saw a few difficulties in the market in the first three months. Demand has been satiated by supply so far, but in the summer months we have seen a squeeze in corporate bond markets. Pure corporates – not including collateralised debt or sovereigns – are up

4% over the year in terms of total returns. That grab for risk has been most strongly felt in high yield – European high yield is up 40% over the year to date.

Q: To what extent has the financial crisis led to many more companies trying to raise money through corporate bond issuance?

A: Banks are still in a hard position however you cut it - they have to reduce the leverage on their balance sheets. We believe banks are pushing corporates to come to the bond markets to alleviate the pressures on bank balance sheets.

Yes, we are seeing more issuance on the back of what’s happened [in financial markets] and although some people are expecting this to dry up, we think we will continue to see it from two sources. One is companies looking to pre-fund. They might not need money for 2009, but want to secure funding for 2010 and 2011. They want surety of funding for any refinancing they need to do, or they may have views on inflation and want to lock in yields.

The second source is the disintermediation tack, where smaller companies are coming to the bond market to do small corporate bond deals rather than borrowing from banks. These are usually businesses of a few hundred million in size. We have seen this recently with gas and electricity companies, such as Wales & West Utilities.

Q: What is the outlook like for defaults in the corporate bond sector over the coming year? Are these priced in?

A: In the investment grade market you won’t see a lot of defaults. A bigger risk is rating migration. The ratings agencies have taken a hammering from the regulator and now they are not willing to give companies the benefit of the doubt and keep them at investment grade level rather than just junking them. It is easier to downgrade those companies that are on the cusp than take the risk. Some bank bonds have up to 10 notches of difference between their ratings from Moody's and S&P. A big risk as we move through the next year-and-a-half is how they treat these ratings and what they are going to do with them. I think the agencies will continue to be conservative. You are seeing businesses that are low and mid BBB-rated that are going to equity markets and holding rights issues to allow themselves to deleverage so they can retain their ratings.

Q: So are you saying you agree that ratings agencies are unreliable?

A: A lot of people are willing to bash ratings agencies, but I am not in that camp. They do make mistakes on occasion, however, there is no right or wrong answer in terms of what a company’s rating is. It is just an opinion, and it is a tough job.

Q: Recent large issuance of government bonds by the Bank of England prompted a sell-off in the gilt markets, as the Financial Times reported last week. What do you think the significance will be over the long-term of such a great supply of gilts flooding the market?

A: This was misrepresented in the FT. It was actually a syndicated deal. In the past, the gilt market was only done through auction, but because of the huge supply you can now do syndicated deals just like in the corporate bond market. The £3 billion issue was upscaled to £5 billion, and yes, the MPC’s comments caused the gilt market to sell off, but ultra-longs have been very stable and have not sold off anywhere near as much. We are seeing gyrations and fluctuations around gilt yields, but only the most bearish investors think gilt yields will be lower in two years time. The MPC isn’t shocking people by saying yields will be higher.

Q: What effects have the government’s quantitative easing measures had on bond markets, especially in terms of interest rate cuts?

A: This is an impossible question to answer as no-one knows what gilt yields would have done without quantitative easing. The Bank of England wanted to stimulate the economy not reduce gilt yields. You could surmise that if the government had not been buying bonds through quantitative easing, gilt yields would have been much higher.

Q: The Investment Management Association reports that the Corporate Bond sector was the most popular among retail investors in the second quarter. What do you think is driving continued inflows into these funds?

A: People’s perception is that they cannot get any return on their cash. Bank accounts are typically yielding between zero and 3%, so investors are looking for any way to make a return. Many people don’t understand the duration impact on bond yields. Our Sterling Credit Advantage fund is good for these investors because it takes out the duration aspect, so over the long term investors are not at risk of government bond yields rising. Most people would accept that bond yields are going to rise as interest rates go up.

Q: Where are you finding opportunities in the fixed income market?

A: We are seeing opportunities in the lower tier two and senior part of the bank capital structure. We won’t see loss on senior debt because empirically in the UK we have not seen that – governments are standing behind these senior bonds. Certainly in Europe that is our view. [These assets] are earning 300 basis points above Libor [London interbank offered rate]. This is a 3% return, which is very attractive over the long term.

We bought lots of utilities and telecoms when they were very cheap, and tobacco and alcohol where they had capital and a low risk of default. In general, this strategy is the same across all the funds in the range.