Cover story | Corporate bonds
Debt Management Office, as interest rates were sliced by central banks. Given the gap- ing deficits some pensions had to make up following the crisis, a steady 2% return (or lower) was not going to cut it. Elsewhere, investors in some European government bonds have also ended up paying the state for the privilege, something that goes against the grain for those with liabilities to meet. Corporate bonds, therefore, seemed to be the best bet for pensions post-crisis, as even a couple of percentage points of spread looked like the way to get back on an even keel – and there was plenty to choose from.
2009. Investors bought bonds worth more than $1.75trn (£1.3trn) from companies in the US, Europe and other developed mar- kets in 2017 alone, according to data provider Refinitiv. The trend was accelerated by Central Banks buying existing corporate bonds as part of QE. By becoming the lender of last resort, they gave confidence to investors to buy new issuances. Over the past three years the ECB alone has pur- chased some €177.7bn (£153.9bn) in corpo- rate debt. But investors are discovering that there might be a sting in the tail to all their well- intended bond-buying.
There are places where you can get a
good return for the risk you take, but the question is where to find it. Andy Cheseldine, Capital Cranfield
With borrowing costs at their lowest point in decades, companies in all sectors and from all over developed markets began to tap investors for capital.
Against this backdrop, some 20% of respondents around Europe told Mercer at the start of 2018 that they were looking to buy even more corporate debt. Roll forward just 12 months, however, and things have begun to look very different.
STING IN THE TAIL
Unlike many well-laid plans, the one to get companies issuing lots of cheap debt worked. Each year that followed the finan- cial crisis saw global issuance records being broken. By the end of 2018, some $9.2trn (£7trn) of corporate debt was outstanding in the US – the world’s largest debt market – up from $4.6trn (£3.5trn) in 2005. Moody’s said in February that US non-financial corporate debt rose to a record 46% of GDP in Sep- tember 2018 – beating the previous record that had stood since the second quarter of
36 | portfolio institutional | April 2019 | issue 83
Central banks, who brought down interest rates to encourage lending and borrowing, are now warning about the volumes of debt that companies are carrying. In June 2018, the Bank of England was one of several developed market financial regu- lators to say it was worried about the level of debt in the US and thought risky corpo- rate borrowing in the UK was a becoming a concern, too. This served to put the brakes on issuance, according to Refinitiv, with around a quarter less debt being sold than in the previous year.
This leaves investors with a couple of real
conundrums.Firstly, as the equity bull mar- ket begins to stutter and government bonds are not a viable option – where should they look for yield? Jennifer Bishop, one of the managers on Willis Towers Watson’s (WTW) £3bn alter- native credit fund, says that her team is staying away from investment-grade bonds. “Companies are overleveraged – invest- ment grade in particular – and much of it is low quality,” she adds.
In March, a note by the Bank of Interna- tional Settlements highlighted where most issuance – and investment – had occurred across the corporate bond spectrum in the past decade. In the note the Bank said: “Since the global financial crisis (GFC), investment grade corporate bond mutual funds have steadily increased the share of BBB bonds in their portfolios. In 2018, this share stood at about 45% in both the US and Europe, up from roughly 20% in 2010. As interest rates remained unusually low post-GFC, portfo- lio managers were enticed by the signifi- cant yield offered by BBB-rated bonds, which was substantially higher than for better-rated.” From yields hitting a high of around 8% in the immediate aftermath of the crisis, according to Markit iBoxx, the average for investment-grade credit has struggled to get above 2% since 2014 – and in some cases has been well below it.
Andy Cheseldine, a professional trustee at Capital Cranfield who works for several large pension schemes, questions whether investors were getting enough bang for their investment-grade buck. “From what I have seen over the years, no,” he says. “But we are in a new normal of low interest rates. There are places where you can get a good return for the risk you take, but the question is where to find it.”
SAY YOU’LL BE THERE The second conundrum for investors is the viability of what they have sitting in their portfolios that they bought when lending and borrowing were cheap. One of the biggest questions has become not what to do if a bond defaults, but when. A recent note from Moody’s showed that unlike in previous cycles, the default rate does not seem to be rising in line with the debt-to-GDP ratio. However, many in the market, including WTW’s Bishop, foresee a wave of defaults around the corner as conditions have changed over the last decade. “So many companies are overleveraged,” Bishop says.
“Borrowing was what was getting the econ-
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