Can corporate bond funds add zest to portfolios?

Ken Rayner, investment director at Rayner Spencer Mills, looks at whether corporate bond funds should feature in your fund mix.

Corporate Bond funds are defined as those that invest at least 80% of their assets in sterling denominated (or hedged back to sterling), triple BBB minus or above corporate bond securities (as measured by Standard & Poors or an equivalent external rating agency).

This excludes convertibles, preference shares and permanent interest bearing shares (PIBs). Corporate bond funds are, of course, part of the wider fixed interest asset class, and it is in this wider context that we consider them here.

The position for corporate bonds is very much a reflection of what is happening in the wider fixed interest market. Since the beginning of the financial crisis investors have sought safe haven investments, initially gold, but increasingly highly rated sovereign debt.

This has, over time, forced yields on this debt down to incredibly low levels in particular in US treasuries, despite the rating agency downgrades. This has caused the spreads between these assets and corporate bonds to widen significantly in particular, in the high yield market.

Spreads

The implied risk in the various types of corporate debt has therefore often looked very attractive compared to historic spreads given the lower than anticipated default rates.

During 2011 those investing in longer duration gilts and treasuries have had a good year with returns in long duration assets being very strong, well over double digit returns. The returns in the corporate market have been solid but not as strong, around 9% (source M&G), provided we remove the financials element from the figures.

The high yield market in Europe and the UK has seen negative returns in 2011 due to the economic slowdown but when we consider that equity markets are down by some 20% in Europe and 7%-8% in the UK, this is a reasonable performance. The market in the US has been more positive in high yield thanks to the aggressive refinancing and extension of debt maturities of these companies resulting in lower overall leverage levels.

We feel that the spreads in the market today compensate investors favourably compared to the likely defaults –the threats are far less than in 2007 with many of the weak credits having already defaulted or restructured, and much reduced inventories meaning fewer forced sellers in any further crisis.

Good companies with strong cash flows have generally been reducing their debt burdens which is a positive, subject to the right level of investment also taking place to stimulate growth.  

The difficulty for investors is interpreting what the right balance is for future economic conditions. At some point these companies will have to use the cash to benefit shareholders or invest for the future of their business.