AA-rated Chris Bowie, manager of the Ignis Corporate Bond fund, explains where he is turning to in the hunt for income.
Sovereign bond yields are close to all-time lows, debt to GDP ratios are looking stretched on any historical basis and the US and UK are printing record amounts of money.
With history not favouring fixed income investors when money is being printed and the stock of government debt excessive, the key question now is why should any risk-averse investor buy bonds with such a low level of absolute yield?
The question is valid. For credit specifically, my return projections for the next 12 months look extremely modest. The average yield on European corporate bonds is 2.4%, and investment grade credit is unlikely to beat this.
The reason I believe overall corporate bond yields will not fall, and therefore not generate capital gains, is that while spreads are relatively attractive, government bond yields are not fully compensating for the headwinds facing fixed income over the next few years.
One of the main risks is that the monetary experiments being conducted in the US and the UK in the form of quantitative easing (QE) are relatively unproven, and in my view increase the likelihood of future inflation.
Of course timing is key, and in the near term there are equally large risks of wage deflation and balance sheet deleveraging at the consumer, corporate and government level, all leading to generalised price declines. These forces will likely keep a lid on inflation in the near term. But at what point will printing money lead to a generalised price rise?
QE and inflation
This is a difficult question to answer and one I cannot predict with any certainty. History can, however, often help make informed choices about the future and it teaches that printing money often leads to inflation.
Japan is the possible exception but electorates in the West are unlikely to accept two decades of lost potential output and employment – and that is why ultimately I think inflation is a more likely outcome. Contrasting this view of the risks of rising sovereign bond yields, I am relatively bullish on certain credit sectors, such as corporate hybrids.
These bonds are generally issued by large stable companies, such as German utility EnBW and energy company BG Group. They offer two to three times the yield of the senior debt, and while they are rated two to three notches lower, their volatility is far less than that of financials.
I also like sectors where investors are protected by physical asset backing. Examples include companies in the UK like Tesco and Sainsbury’s, where investors can buy bonds that yield between 4% and 5% and are backed by physical supermarket properties.
Similarly, utility asset-backed positions, such as Thames Water or Yorkshire Water, provide investors with physical backing that reinforces the credit worthiness of the bonds, and offer sensible levels of yield.
Where I particularly dislike the risk-reward profile of credit is in banks. Given their extremely high correlations to euro sovereigns and with the constant pressure to rebuild capital ratios in the form of regulatory and self-imposed capital requirements, banks will continue to be a high beta sector with plenty of volatility and uncertain returns.
In summary, the return outlook for credit is for low single-digit returns over the immediate future with a certain degree of volatility. Those returns may be better than the paltry returns from cash, and possibly better on a volatility-adjusted basis compared to equities, but credit will struggle to generate a positive real (ie, inflation-adjusted) return in an environment of record high debt, record money printing and record low yields.
In these conditions, investors may favour a low beta strategy with an element of defence that physical asset-backed holdings provide.
Chris Bowie is manager of the AA-rated manager of the Ignis Corporate Bond fund which has returned 36.84% over three years compared to a 30.45% rise in the Markit Sterling iBox Sterling Corporates index.