Corporate Bonds Looking ahead
Having posted strong returns since 2008, Danny Vassiliades questions whether investors should rethink their approach to corporate bonds this year
Corporate bonds remain a key asset class for any portfolio. Because of the additional credit risk compared with a sovereign bond, corporate bonds should generate an additional return. What we have seen over the recent years and months is that the ‘credit premium’ available on corporate bonds has been reducing.
This is demonstrated in Chart 1 below, which shows the credit spread on AA rated long-term corporates falling to well below 1% per annum, significantly lower than its peak in the financial crisis of 2008. This has meant that holders of corporate bonds have seen greater returns over this period compared with equivalent sovereign bonds as capital values have risen.
We have also seen this reduction in credit spreads on corporate bonds of differing credit quality, as shown in Chart 2. Despite some short-term movements in credit spread between bonds of differing credit ratings, the credit spread is highly correlated and at 31 December 2014 showed a narrowing spread between bonds of different ratings.
Strong returns
This data shows us that corporate bonds have delivered strong returns since 2008 and are now potentially reaching a point where it is difficult to see how the credit premium could drop much further without the risk of credit defaults being inadequately compensated. This points to two conclusions for investors and pension schemes.
Chart 1: Credit Spread: 10 Years to 31.12.14
Firstly, if corporate bonds are being held to provide some interest rate protection in preference to sovereign bonds, it may be time to rethink whether sovereign bonds would be a more appropriate investment. In short, holding significant corporate bonds exposes the investor to a reversal of the tightening of the credit spread. In such a scenario a Government bond would be a more secure alternative, as well as providing interest rate protection.
Secondly, if corporate bonds are being held for return purposes, then the investor has done well since 2008. However, looking ahead, the absolute return on high quality corporate bonds held to redemption is less than 1% per annum more than Government bonds, in contrast to 2008 when it was in excess of 2.5% per annum. Investors may wish to diversify their sources of return away from corporate bonds if they wish to generate greater return potential.
Future prospects
Looking into 2015, there are a number of influences on the corporate bond market that will influence their return prospects. The main risk to returns remains the appetite of investors to price credit risk benignly.
Should there be a ‘Grexit’ and a sequence of bank losses and collapses, then we could expect credit premiums to rise as investors reassess their pricing of risk, favouring liquidity over returns. This would cause corporate bond values to fall and for returns to drop. The main potential for
ilp
returns lies with the prospect of deflation taking hold in Western economies leading to the absolute returns offered by bonds generally, and corporate bonds in particular, remaining attractive to investors.
Corporate bonds have exhibited strong returns since 2008 as investors have continued to cut the returns they require in compensation for accepting the credit risk inherent in this asset. This has been shown across bonds of all types of credit rating.
Looking forward, returns will be sustained if we foresee a long-term deflation taking hold. Should there be a liquidity and credit risk similar to that of 2008, owing to problems in the eurozone, the return potential for corporate bonds could, however, be bleak.
Danny Vassiliades is Head of Investment Consulting at Punter Southall
Chart 2: Credit Spread 10 Years to 31.12.14 for corporate bonds of different ratings
March 2015
Investment Life & Pensions Moneyfacts
®
9
Page 1 |
Page 2 |
Page 3 |
Page 4 |
Page 5 |
Page 6 |
Page 7 |
Page 8 |
Page 9 |
Page 10 |
Page 11 |
Page 12 |
Page 13 |
Page 14 |
Page 15 |
Page 16 |
Page 17 |
Page 18 |
Page 19 |
Page 20 |
Page 21 |
Page 22 |
Page 23 |
Page 24 |
Page 25 |
Page 26 |
Page 27 |
Page 28 |
Page 29 |
Page 30 |
Page 31 |
Page 32 |
Page 33 |
Page 34 |
Page 35 |
Page 36 |
Page 37 |
Page 38 |
Page 39 |
Page 40 |
Page 41 |
Page 42 |
Page 43 |
Page 44 |
Page 45 |
Page 46 |
Page 47 |
Page 48 |
Page 49 |
Page 50 |
Page 51 |
Page 52 |
Page 53 |
Page 54 |
Page 55 |
Page 56 |
Page 57 |
Page 58 |
Page 59 |
Page 60 |
Page 61 |
Page 62 |
Page 63 |
Page 64 |
Page 65 |
Page 66 |
Page 67 |
Page 68 |
Page 69 |
Page 70 |
Page 71 |
Page 72 |
Page 73 |
Page 74 |
Page 75 |
Page 76 |
Page 77 |
Page 78 |
Page 79 |
Page 80 |
Page 81 |
Page 82 |
Page 83 |
Page 84 |
Page 85 |
Page 86 |
Page 87 |
Page 88 |
Page 89 |
Page 90 |
Page 91 |
Page 92 |
Page 93 |
Page 94 |
Page 95 |
Page 96 |
Page 97 |
Page 98 |
Page 99 |
Page 100 |
Page 101 |
Page 102 |
Page 103 |
Page 104 |
Page 105 |
Page 106 |
Page 107 |
Page 108 |
Page 109 |
Page 110 |
Page 111 |
Page 112 |
Page 113 |
Page 114 |
Page 115 |
Page 116 |
Page 117 |
Page 118 |
Page 119 |
Page 120 |
Page 121 |
Page 122 |
Page 123 |
Page 124 |
Page 125 |
Page 126 |
Page 127 |
Page 128 |
Page 129 |
Page 130 |
Page 131 |
Page 132 |
Page 133 |
Page 134 |
Page 135 |
Page 136 |
Page 137 |
Page 138 |
Page 139 |
Page 140 |
Page 141 |
Page 142 |
Page 143 |
Page 144 |
Page 145 |
Page 146 |
Page 147 |
Page 148 |
Page 149 |
Page 150 |
Page 151 |
Page 152 |
Page 153 |
Page 154 |
Page 155 |
Page 156 |
Page 157 |
Page 158 |
Page 159 |
Page 160 |
Page 161 |
Page 162 |
Page 163 |
Page 164 |
Page 165 |
Page 166 |
Page 167 |
Page 168 |
Page 169 |
Page 170 |
Page 171 |
Page 172 |
Page 173 |
Page 174 |
Page 175 |
Page 176 |
Page 177 |
Page 178 |
Page 179 |
Page 180 |
Page 181 |
Page 182 |
Page 183 |
Page 184 |
Page 185 |
Page 186 |
Page 187 |
Page 188 |
Page 189 |
Page 190 |
Page 191 |
Page 192 |
Page 193 |
Page 194 |
Page 195 |
Page 196