Corporate bonds | Cover story


omy going, and regulators were mainly focusing on the consumer after the crisis, so now we are at 2007 levels of corporate debt – if not higher.”


An additional factor has been the weaken- ing of many debt and bond covenants – tak- ing advantage of a desperation for yield – that means investors often do not find out about a default until the last minute, when there is suddenly no room to move. This phenomenon of “cov-lite” deals, which has worked its way down to even some of the lowest quality corporate debt, may have contributed to the stubbornly low default rate, which Moody’s said sat at 2.6% in October, its lowest level for three years. A rate rise is usually enough to start a wave of defaults, but as the US seems to have pulled back on its path to normalising eco- nomic policy many companies – and their debt holders – may have earned a brief reprieve. However, even if there are no rate


rises on the horizon,


Bishop believes the profitability of some of these over-levered companies is not sustainable. The so-called “zombie compa- nies”, which have been given an extended lifeline by quantitative easing and purposely soft eco- nomic conditions, may be the first to fall. It


is therefore imperative to


choose the right bonds, says Cheseldine, who advises some of the City’s largest pension funds.


“There are lessons that people should have learned about defaults in 2008,” he adds. “You should not just be looking at the rate of return vs the likelihood of default, but the recovery rate, too. Experiencing the loss of a bond is not the end of the matter. “The most important thing for pension funds to do is look at their managers’ recov- ery process and skill set,” he says. “When it all goes wrong, how are they going to get their money back? In a shocked market, which could happen sooner rather than later in my opinion, this will make the dif- ference between a good and bad manager.” Krzysztof Lasocki, senior investment and


Bishop at WTW is also a fan of securitised mortgage mortgages. “We like consumers more than companies,” she says. In the US, after the crisis, mortgages fell under a raft of new regulation and availabil- ity has been pulled right back, according to Bishop. “While companies have become more and more leveraged, the consumer is around a third as leveraged as in the run up to the crisis.”


Indeed, according to Moody’s, at the peak of the crisis, total liabilities as a percentage of disposable personal income for US households stood at more than 130%; today it is around 100%. As an economy, the US gives hope to inves- tors due to its strong fundamentals and


finance analyst at the Royal Mail Pension Plan, says that yields had fallen everywhere and, despite a strong first quarter, 2019 looks like it will be a tough year so good portfolio positioning is critical. Lasocki adds that his team was moving away from corporate debt in favour of asset backed secured (ABS) finance. “There are many reasons to be bullish about European ABS because this is one of the few areas that will not be affected when the European Central Bank pulls the plug and all the other assets with valuations inflated by the asset purchase programme will suffer,” Lasocki says. “Also, mortgage-backed securities in conti- nental Europe are strong and secure, with models showing a huge distance to defaults so there is a lot of safety cushioning even if some sort of crisis reappears.”


highly-employed consumer driving demand, Lasocki says, but adds that he is keeping an eye on bond activity as a leading indicator.


In recent months, market commentators have noted the yield curve of the US treas- ury inverted – and it spooked many inves- tors. “There is some statistical significance to the predictive power of the yield curve inversion as there were only two false alarms in the past and pretty much every big crisis was preceded by it,” Lasocki says. “This is a strong warning signal,” he adds. “Maybe the last order bell is not ringing just yet but 2020 looks more and more a likely year for a clear end of this cycle.”


DON’T MIX, JUST MATCH For independent pension consultant John Ralfe, if you are asking which type of bonds will get you to full-fund- ing and beyond, you are asking the wrong question.


Maybe the last order bell


is not ringing just yet but 2020 looks more and more a likely year for a clear end of this cycle. Krzysztof Lasocki, Royal Mail Pension Plan


“There is no magic formula,” he says. “The company spon- soring the pension has made a lot of promises that have turned out to be more expen- sive than they expected.” He adds that managers and consultants would try to push new products to match assets to


liabilities, but the market had seen – and would continue to see – many flavours of the


month come and go.


“Once you have worked out what you need to match, it is all variations on a theme,” Ralfe says. “Pension trustees who are try- ing to beat the market are looking for a unicorn.” However, Bishop warns that despite being encouraged about pension funds match- ing their cash-flows with their liabilities, they could still come unstuck by paying too much. “A lot of the assets pension funds are buying are massively overbid,” she says. “This means some are buying high- yield debt to match their cash-flow, but just look at the default assumption. People are paying too much for cash-flow matching while there is still value elsewhere.”


Issue 83 | April 2019 | portfolio institutional | 37


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