The asset class par excellence: corporate bonds

Debt market specialists have been drumming for months: Bonds are back.

Now, that message seems to have gotten through — particularly in corporate bonds — clearly enough that the bet’s popularity is one of the few things they think could hold back the asset class, at least in the short term.

Of course, the financial markets had a pretty terrible run in 2022, both for stocks and bonds. Corporate bonds in the US are down about 14 percent for the year, according to data from ICE and Bank of America, and that’s the safe, even generally (whispers) boring, investment-grade paper — not the risky, high-yield stuff, that often impolitely referred to as “garbage”.

But dismal price action has pushed yields to some of the highest levels investors have seen in two decades. Corporate bonds denominated in euros started 2022 with a yield of around 0.5 percent. Now investors can get more than 4 percent. That’s still less than inflation, sure, but it’s a serious improvement, and it means buyers are getting as much yield on safe, stable investment-grade debt now as they did on faster-paced, more default-prone high yield a few months ago.

“Mid Single Digit Returns on Fixed Income? That’s good enough,” said Tatjana Greil Castro, co-head of public markets at credit investment house Muzinich & Co, who was more bullish on the asset class last September. “If you want high single digits or, if you’re lucky, double digits, go into the stock markets.” As a result, she no longer feels the need to get into shakier companies or into longer-dated bonds with greater sensitivity to benchmark rates in order to get decent yields to achieve.

“Taking a very small risk already makes the end customer happy,” she says. “Investors don’t say ‘go and shoot the lights out’. They want steady returns.”

Specialists are suddenly in demand. The much higher yields now available have “put people back into the conversation,” says James Vokins, who heads the investment-grade team at Aviva Investors. “‘Sweet spot’ is the right word for now,” he says, as new clients want to protect themselves from the madness of equities or get credit exposure without risking the crisis-prone ride of distressed high-yield bonds.

Of course, no sweet spot lasts forever. One reason for caution is simply that everyone suddenly seems to love corporate bonds. The supply of new bonds in the market is strong enough to offset that for now, but portfolio managers say they’re a little nervous it could turn into a crowded bet.

Aviva’s Vokins also warns that investment-grade bonds will be priced to perfection, not after any hiccups, which could come later this year in the form of further unwinding of bond purchase programs and other central bank liquidity actions, or where it’s expected to be very large volumes of government bonds will be issued in the coming months.

“We’re moving pretty hastily towards pricing in a lot of good news,” he says. “If you’re managing a large portfolio, you need to be prepared for the next step – we need to be very aware of that and approach the markets a little more cautiously as the year progresses.”

Still, some major shifts in asset allocation appear to offer long-term support. “What it really comes down to is that institutional investors have made a broad shift away from public markets and into private markets and equities over many years because public bond markets just weren’t generating enough returns,” said Sonal Desai, chief investment officer for Franklin Templeton Fixed Income. This has resulted in many of these large investors having exposures to the asset class that are small by historical standards.

Now, she says, investment-grade buyers can expect a yield of about 5 percent, and the big shift back to that type of debt has yet to go further. “I think that’s the story,” she says. “In a way, this redistribution is going to be a bit bumpy, but it has to happen.”

Another appeal for Greil Castro at Muzinich, aside from signs of steady improvement in the eurozone economy, is that even if she buys debt at say 90 cents on the euro, she’s fairly confident they’ll pay back the full 100 cents will when the debt matures, unless there is a truly catastrophic recession. Corporate balance sheets are in good shape thanks to all the cheap credit they took out in the immediate aftermath of the Covid outbreak.

So if you stick with relatively short-term debt, “your relationship with the market becomes less and less important,” says Greil Castro. “After all the turmoil, I think a little bit of rest is much appreciated.”

This makes it feel like a cozy place. “If you have volatility, start with a [yield] close to zero, you can feel it clearly,” says Greil Castro. “If you run naked in the cold you will feel it, but if you go out with a warm winter coat you can take it much better. Now we have a warm winter coat and boots for bad weather, so we are well equipped.” The asset class par excellence: corporate bonds

Adam Bradshaw

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