After the good times, when will the bond hangover kick in?


Love your iPhone, your iPad and your iPod? So why not own some iBonds too? People who have delegated much of their daily tasks and leisure choices to the technology wizards from Apple had the opportunity in April to trust them with their savings too.

For the first time in almost two decades, the legendary Cupertino-based company launched an offer of corporate bonds that aimed to raise $17bn from investors. The debt, issued in various forms, was quickly gobbled up by the market, with investors reportedly ordering more than three times the amounts being issued. Not surprisingly, perhaps, considering the reputation of a company that is famous for being able to pile up cash more easily than you can organise your music collection in iTunes.

Except that, differently from the usual reception of a new gadget released by Apple, the “iBonds” failed to impress some of the most sophisticated buyers in the market. For instance, mega-investor Warren Buffet, himself a kind of Steve Jobs of finance, rebuffed the opportunity, arguing that the yields paid by Apple, at 2.415 per cent for the 10-year bond and 3.883 per cent for a 30-year one, were far too low.

Others complained that the reasons behind the issuance did not look particularly prone to benefit fixed income investors. “The bond was clearly designed to fund a shareholder-friendly course of action,” says Jon Mawby, manager of the GLG Global Corporate Bond fund.

The Apple bond issuance illustrated well the current state of the market for corporate bonds, an asset class that has remained hot in the past couple of years. Conditions have been so favourable to borrowers that even companies that used to avoid increasing their debt, like Apple, are coming into the market. Demand has far outstripped the supply of new bonds, flattening yields and making it very cheap for issuers to change old debt for new one. Some have also raised money to make investments or to pursue other goals, like the payment of dividends to shareholders.

Indeed the use of debt issuance has been so expanded that it has raised red flags on the viability of the play from the point of view of investors, but the latter carry on buying corporate bonds like hot buns anyway.

Yields have fallen so much that the market may look set for a turnaround. Owing to exceptional circumstances, however, it could still have quite a bit of air in its lungs. And the most exceptional driver of the current situation is the loose monetary policies that have been implemented by the central banks of the developed world.

“Quantitative easing is like the alcohol in a punch bowl,” says Bryn Jones, manager of the Rathbone Strategic Bond fund. “People are drinking now from the punch bowl and having a great time. If someone keeps pouring alcohol in, everybody will keep on drinking and enjoying the party. But as soon as there is no more alcohol left, people will start to sober up and could end up with a hangover.”

In the meantime, however, the many investors who still have an appetite for corporate debt are likely to keep on finding options to buy into the asset class. New issuances are reaching the market at a pace rarely seen before, as even European firms, which are traditionally reliant on banks rather than capital markets, have taken the bond road.

Their emerging market peers have also embraced the new environment, and Brazil’s oil giant Petrobras broke new grounds for the group by selling $11bn-worth of debt in mid-May. It thus set a new record for a corporation based outside the industrialised economies, and the offer was oversubscribed to an extent that it prompted Petrobras’ financial director to announce that a new issue, this time in euros, is already in the oven.

Markus Wiedemann, manager of the DWS High Income Bond fund, says: “Credit has become a more interesting asset class for retail investors since the start of the financial crisis.”

He notes the market has gone through some ups and downs in recent months because of short spurts of panic, like when the Italian elections proved to be inconclusive, or during the brouhaha created by the Cyprus banking crisis. But in the end such episodes proved to be entry opportunities in the market as the positive trend resumed.

“There has been a big hunt for yield, and corporate bonds have been very good sources of income returns and capital gains as well for the last three years,” adds Chris Bowie, manager of the Ignis Corporate Bond fund.

It is not surprising in fact that fixed income investments become a refuge for investors in times of economic uncertainty. The difference this time is that the usual safe vehicles, such as sovereign bonds sold by rich countries like Germany, the UK or the US look less palatable than ever. With interest rates set to record-bottom levels for the foreseeable future, returns on US Treasuries, UK gilts and German bunds have drifted towards nought, and some people believe they could soon become negative, once inflation is included into the equation.

On the other hand, the panic that took hold of the the market during the worst stages of the eurozone crisis appears to have abated for good since a breakthrough intervention in the debate by the president of the European Central Bank, Mario Draghi, last year.

Many investors had decided by then that the time had come to make their money work a little harder. A good number of them opted for equity markets, explaining the recent rally of US and European stocks. But it is always a good policy to allocate a share of one’s portfolio to fixed income instruments in order to diversify risks. With sovereign bonds looking either unappealing, or too risky in the case of rich countries that pay higher yields, like Spain or Italy, corporate debt has emerged as the most viable option.

“Since Draghi’s speech last summer, it has been pretty much a one way trading, with tighter spreads for the past nine months,” Wiedemann says.

Other elements must be factored in as well to explain the increased appetite for corporate bonds. From a fundamental point of view, Wiedemann notes, companies have been doing very well, which means that credit metrics are solid. The global rate of default among speculative rating companies closed the first quarter at a mere 2.4 per cent, down from 2.8 per cent three months before, according to Moody’s, a rating agency.

The lack of bad news in this area may have diluted the sense of added risk that many issuances would have woken up in investors’ minds under different circumstances. Also, Wiedemann says, the macroeconomic environment, particularly in Europe, with flat and even maybe even negative growth, helps credit to do well. 


Furthermore, there are some kinds of institutional investors that are required to both invest in safer fixed income vehicles and look for some kind of returns, a combination that sovereign bonds can hardly offer at the moment. They are the likes of pension fund managers and insurance companies, which have to meet long term liabilities with similarly long term assets, and cannot therefore put all their eggs into a volatile and uncertain basket of equities. So many have seen in corporate bonds a valuable option to meet their actuarial challenges.

“In the UK it has always been the case,” says Rathbones’ Jones. “But now it is happening elsewhere too. The German pension market is growing fast, and so is the Dutch.”

The looming introduction of Solvency II, a European directive which will change the capital requirements for insurers, is also expected to turn corporate bonds into the most attractive asset class for some giant institutional investors. Many may therefore have been hitting the market in order to prepare their portfolios for the arrival of the new rules, which could take place in 2015.

“Excess structural demand for credit is increasing at the time where there has been a general deleveraging, especially in the financial sector, which is issuing less bonds,” Jones says. “There has been an excess of demand and a lack of supply, and basic economics teaches that this situation means that asset prices will go up.”

In corporate bonds terms, that means the spreads that issuers need to add on top of sovereign bond rates in order to make their debt attractive have become ever lower. Which means that the cost of borrowing for firms has reduced significantly.

“Overall, the yields for high-yields bonds have compressed too much,” Bowie says. “Now we can see very speculative companies issuing debt at 6 per cent a year, and that is too expensive.”

The fall in yields have been so sharp that the US Corporate High-Yield Bond Index published by Barclays fell below 5 per cent a year for the first time ever in early May.

Cheaper credit for companies, however, means that buyers of corporate debt are likely to find it more difficult to obtain the kind of results that have been achieved of late.

Alex Smitten, manager of the Cazenove UK Corporate Bond fund, says: “It seems it will be hard work to match the performance of last year, when investment grade corporate bonds returned 13 per cent.” The forecast was reinforced by the returns delivered by the same type of corporate bonds in the first five months of 2013, which hovered at about 4 per cent, according to Smitten.

The experts agree that the destiny of the market lies much with the decisions to be taken by central banks regarding their monetary policies. While money remains cheap, investors are likely to keep on adding bonds to their books, and yields could continue to slide. The addition of the Bank of Japan to the team of QE enthusiasts has created even more liquidity in the market, boosting the potential demand for corporate debt.

It does not look likely that the European Union or the UK will increase their interest rates either, considering the dismal performance of the real economies in both. The main threat could come from the US, where the economy is doing a tad better and the housing market has provided signs of renewed life. This could convince the Fed to harden its stance at some point in the future.

This could be a worry because a change of monetary policy by one or more of the main central banks constitutes the main threat to the corporate bond play at the moment. Tighter monetary policies would imply higher sovereign bond yields, reducing the ability of corporate debt to provide gains, and making some of the most expensive papers sold to investors recently to look less like a good deal.

In May, there already were a couple of days when market sentiment appeared to be changing thanks to differing interpretations of central bank minutes and positive economic news coming out of China. But they were short-lived and many investors believe the conditions that have prevailed in the market since mid-2012 still have some way to go. “There is a potential to see negative total returns during the year, depending on the volatility of the underlying bond market, but that is not the scenario we are working with,” Wiedemann says.

Here, the analogy between QE and the availability of alcohol in a party comes handy too, as abundant liquidity appears to turn into kissable damsels a number of bonds that would otherwise appear much less attractive.

“If you believe interest rates will remain close to zero, achieving returns of 3 per cent with a corporate bond does not look bad at all,” Smitten says. In fact he notes that the main thing to be considered is the difference between the rates paid by corporations and those of sovereign bonds.

“Spreads for corporate bonds are still nowhere near the low levels they reached six or seven years ago,” Smitten points out. “So there is still potential room for corporate bonds to outperform government bonds.”

But expectations should be adapted to ever shrinking yields, according to Wiedemann. “If you buy corporate bonds now, you can expect to receive the coupon, but very limited capital gains,” he says.

Euan McNeil, manager of the Kames Investment Grade Bond fund, says: “Lower yields are just a function of central banks being on hold and an expectation that is becoming consensual that they are going nowhere in rates.” He adds the play has quite some track left considering the current economic conditions.

“On a relative evaluation perspective, corporate bonds still are attractive compared with government debt and cash. From a fundamental point of view, the balance sheets of companies has been in a such rude health that they have provided an additional support to investors.” 


Even if Europe and the US eventually manage to resume the road to sustainable economic recovery, few people believe they are likely to become fast performers any time soon. And Jones notes that a blah economy, where GDP growth is modest, ranging between 0.5 per cent and 2 per cent a year, provides ideal conditions for corporate bonds to thrive. That is because, when the economy is contracting, default rates tend to rise, spooking lenders. And a similar phenomenon can happen when the opposite situation is in the cards.

“The other time defaults get high is when the economy is growing very fast,” Jones says. “This is where I see the main risk for credit. When growth starts to pick up, companies start releveraging. They take more debt, which is fine if they can generate earnings. But if growth then stalls, they tend to fall very quickly, because they do not have enough money to service their debt.”

The consequences of borrowing should actually be part of the equation every time that an investor is considering buying a bond.

“The easiness with which some investment grade and high yield companies have raised funds bolsters their liquidity and postpones to the future the risk of default,” notes McNeil. “But it could possibly create problems in the medium term, as companies that should not have been given financing have been able to raise money.”

He adds that it is important to keep discipline and add only quality companies to a fixed income portfolio. Jones, for his part, says that companies are paying so little to borrow that there is a risk that some can end up borrowing excessively. This could be a problem when things turn around, with the end of QE, a sudden rise of interest rates or some other shock to the system.

Doubts have also sometimes been raised regarding the use companies are making of the money they have been able to get so cheaply. “Companies are sort of gearing up a little now, and the average level of gearing is not really better than before,” Smitten says.

“There has been an increasing amount of borrowing in the corporate bonds market to pay special dividends or other forms of shareholder payments. Some firms are using these incredibly low levels of interest rates to benefit shareholders in certain situations that are not always that bondholders like to see.”

Some investors also prefer to avoid some kinds of high-yield bonds like those issued by companies based in the embattled economies of Southern Europe, even though potential gains are higher than with safer alternatives.

“The one part of the market where we have been effectively zero weighted is European peripherial corporate debt,” McNeil says. “To be very honest, we would have made lots of money if we had owned Italian and Spanish debt. But we feel that is one part of the market where are not sufficiently compensated for the pure economic backdrop. We feel that in that some discipline has been lost in that sector of the market, and we are happy to avoid it.”

He adds: “It is very important that you do not get sucked into every high yield bond that hits the market. Because, when the music stops, or sentiment turns, or the next wave of concerns about the eurozone comes around, it could be painful for your investors if you are holding those papers.”

However, demand has been such that even issuers from economies have been able to place their debts in the market without problem. “Companies from countries like Spain and Italy have been able to easily sell their bonds, even if they have to pay some additional spread compared to Northern European firms,” Wiedemann says.

That is because the order of the day in the fixed income market is the “hunt for yields”, with investors grabbing any opportunities they can find to achieve any kind of returns. The same sentiment is behind the acceptance that issues made by companies from Asia, Latin America and other emerging markets have met among investors. Again, however, the experts recommend caution when exploring this potentially exciting corner of the market.

“We continue to see value in emerging market bonds, but we invest in them in a very idiosyncratic basis,” Mawby says. “It is a stock- by-stock decision, not a regional one.”

For his part, Jones says that good quality emerging market companies have not been an exception to the trend of paying ever lower yields to place their debt. “Some emerging market corporates right now deliver lower yields than emerging market governments, in local currency terms,” he says.

So far this year, however, the corporate bond market has been able to confound the most pessimistic forecasts. Yields have continued to fall, and interest for new issues has been sustained even though investors have also allocated ever more money to stocks.

“Over the last 12 months there has been an expectation that there would be a big sell-off in bond markets in favour of equity markets, but we do not believe in this,” Jones says. Smitten adds: “People were worried that there was going to be an outflow of money from corporate bonds this year, but it has not materialised. The rotation to equities is coming out of cash, not out of the bond market.”