Corporate bond market review
Extremely low bond yields have persisted for some time and investors have become used to them. Furthermore, this trend was accelerated by the Covid-19 pandemic. Somewhat more surprising has been the remarkable recovery in credit spreads since March 2020, when pandemic fears peaked. Indeed, of the near 2,900 bonds in the euro Investment Grade index at end-Feb 2020, only 11% exhibited wider spreads as at end Feb 2021. Those bonds with wider spreads are mainly in sectors most impacted by the pandemic, such as property, leisure and transport.
The drivers of the global recovery are well known, headed by the huge €1.5 trillion expansion of the European Central Bank's balance sheet. Such liquidity in the system clearly supports demand for corporate bonds. In this context, global aggregate indices (which are government bond-heavy) and global aggregate credit indices have both produced solid returns over the last five years.
Rising inflation concerns
Of course, the more interesting question now is: can government and/or corporate bonds provide a similar outcome over the next five years? In this regard, a big, if not the biggest obstacle over the next few years could be higher inflation, something that has not been high on anyone’s agenda since the global financial crisis. However, a strong economic rebound is now expected, helped by both supportive central bank stimulus and large fiscal spending. This is widely expected to put at least some upward pressure on prices, which has resulted in a sharp rise in core government bonds yields over recent months.
In the case of both, 10-year US Treasuries yields have jumped by more than 60 basis points (bps) compared to end-2020, to around 1.5%. In the case of 10-year bunds, yields remain negative but have also been trending up, with a circa 30bps rise since end-2020. As bond prices move in the opposite direction, continued sustained yield rises would be problematic for both government and corporate bonds. So the outlook for inflation is very important. Our view is that inflation will likely rise in the short term as the economic recovery proceeds. However, the magnitude of rises should be constrained by the scarring of the pandemic, potentially higher unemployment and associated spare economic capacity. Furthermore, after an initial spurt, over the longer run we think it’s quite likely that the structural drivers of low inflation will once again dominate.
All this being said, we would agree that inflation risks are now more ‘two-sided’. In this context, the likelihood of the whole bond spectrum doing quite as well as in the past 5-10 years seems less likely. With the debate around inflation risks increasing, volatility in both core yields and spreads is also likely to rise. We think this will call for a much more selective and flexible approach to bond investing. For corporate bond investors, we think a strategy that appears well equipped for such conditions is an unconstrained one.
Benefits of unconstrained corporate bond investing
So what does ‘unconstrained corporate bond investing’, also known as a ‘total return credit’ approach, actually entail? The most important feature is the lack of linkage to any pre-determined benchmark. As such, the investable universe becomes much wider (or ‘less constrained’) which enables much more investing flexibility. One specific example of this and highly relevant from the inflation perspective is duration, or interest rate sensitivity. Most credit indices have quite high duration, which is fine when inflation is low and yields falling. However, the flipside of this is greater vulnerability to higher inflation and rising yields. Unconstrained approaches are typically more defensive in this respect as they tend to have lower duration. Furthermore, they have much greater flexibility to dial down duration if needed.
High conviction investing
Another aspect of an unconstrained approach and an expansion of the investable universe is the ability to look in more places for the most attractive/best value investments. This can include Investment Grade, High Yield, emerging markets, subordinated financial debt and securitised debt markets. In turn, this supports a ‘high conviction’ approach, whereby the fund is comprised of holdings that are strongly liked, as opposed to just ‘relatively liked’. In the context of the generalised strong recovery in credit spreads alluded to earlier, this ability to look more widely gains added importance.
Source: BAML indices, JP Morgan indices for Emerging Markets. Bloomberg, as of 16.03.2021 * Yield to Worst (YTW) Please note where indices are not labelled as “£” we have adjusted the YTW for projected FX hedging costs.
“Beyond duration adjustment, unconstrained credit approaches tend to have many more tools at their disposal to cope with potential inflationary threats.”
Beyond duration adjustment, unconstrained credit approaches tend to have many more tools at their disposal to cope with potential inflationary threats. For example, there is normally scope to increase exposure to lower-rated credits and subordinated debt, which typically tend to be more immune to rising inflation. In addition, an unconstrained approach usually means the ability to invest in floating rate bonds, where any upward moves in interest rates triggers compensating upward adjustments in coupon payments. Needless to say, judgement and selectivity would be important in such cases because moving down in ratings and different bond structures brings additional risks. Other strategies that can be explored for inflation protection include inflation swaps and real yields.
Finally, it is worth noting that one of the downside features which prevented a greater take-up of unconstrained corporate bond investing in the past was the high cost of hedging currency risk back to euros. This was particularly an issue between 2017 and 2019. However, these costs have fallen dramatically in more recent times, supporting the viability of more global and unconstrained investing approaches.
To conclude, an environment of rising inflation, or even just rising inflation expectations, usually implies increased yield volatility. This calls for a more flexible approach to bond investing. An unconstrained investing approach that focusses on total return has produced strong returns in the past and is well equipped for differing economic conditions. More specifically, an expanded investable universe provides more tools to defend against rising inflation and for mitigating downside risks more broadly. At the same time, an unconstrained approach is more suited for investing tactically and selecting high conviction investments as opposed to just relatively liked alternatives.