Chris Bowie, head of credit at Ignis Asset Management, believes corporate bonds have limited upside and could see a capital loss of up to 40% if real gilt yields adjust.
Citywire AAA-rated Bowie, who manages the £256 million Corporate Bond fund, says even though corporate bonds are trading ‘very cheaply’ and may offer opportunities in the short-term, be prepared for a correction ahead.
‘Indeed the difference between the yield on corporate bonds and the yield on government bonds, the so-called ‘spread’, is cheaper now than at any point pre the financial crisis of 2008,’ said Bowie.
Companies are also rewarding investors for taking the additional risk of holding longer-dated bonds.
Sterling investors in US-firm Citigroup, for example, see a yield difference of 290 basis points between a three-year bond and a 26-year bond, a level of steepness that is an incentive to take risk.
‘But is it worth it?’ asked Bowie. ‘In our view, no, not at this stage.’
Bowie said the timing on this trade is running out and that when yields on government bonds are below the level of inflation, they are not sustainable, as history has shown.
‘Ultimately I firmly believe that real yields on gilts will adjust back up towards +2.5%,’ said Bowie. ‘When this adjustment takes place, fixed income returns will be hit hard. As a rule of thumb, credit loses 8% of its capital for every 1% move higher in gilt yields.
‘So, in short, this adjustment will be very painful for credit investors. This leaves the obvious question: when will it happen?’
For the moment, Bowie believes slower inflation is still on the cards. ‘Wage inflation is not a problem in the UK, and consumer prices have retreated from the levels seen in the recent past.’
However, as long as persistent deflation does not rear its head, real yields will adjust upwards, Bowie said.
‘The timing of this adjustment is really difficult to call, but whilst the Bank of England leaves the option open of printing more money, my suspicion is that this is months, or a low single digit number of quarters, away,’ said Bowie. ‘Certainly not years.’
As a result, Bowie is defensively positioned in his fund. He has reduced the duration risk on the fund, by not owning longer-dated bonds.
The fund is also positioned to guard against the risk of a eurozone break-up or further banking crisis, with minimum exposure to financial and consumers.
‘Instead we prefer asset backed securities, such as bonds issued by supermarkets, which provide the reassurance that if a company did default, the bond holders would have the rights to assets such as property, land or machinery,’ said Bowie.
Over three years to 21 June, the fund has returned 56.5%, beating the benchmark’s 40.7%.
Concern over gilts
It is not just corporate bonds, though, that managers are concerned about.
Fidelity's A-rated bond fund manager Ian Spreadbury recently said gilt risks are 'asymmetric', with yields able to go below 1% but also rise above 5%, if there are concerns about the credit quality of the UK.
Despite certain managers saying there is little inherent value in gilts, they serve a portfolio construction role in so far as they are still, to an extent, a safe-haven if the situation deteriorates in Europe.