Corporate bonds come back strong

The corporate bond sector has bounced back in this latest broad market rally reaffirming a belief among investment strategists that the asset class had too much risk.

“Our philosophy has been to overweight spread product throughout the cycle,” says Darcy Briggs, vice-president and portfolio manager with Bissett Fixed Income management team, a subsidiary of Franklin Templeton investments. “We are overweight spread products currently. Corporate, municipals and provincial bonds are spread products [which have a yield in excess of a federal government bond].”

A big reason for the run-up in corporate bond valuations is the default rate being priced is now merely bad compared to the catastrophic risk pricing non-government bonds were pricing in.

“They are off their Armageddon or stressed high spreads. They are still elevated on a historical basis. They do offer relative value opportunities,” Briggs says. “At their widest spread levels, these surpassed the widest levels we’ve seen since 1980. We hadn’t seen anything like this since 80 years ago. It was pricing in a depression type of scenario. That has been addressed by the fiscal authorities, I think what we have now is more a recessionary situation and I think spread will come back to reflect that.”

To put this in terms clients will understand, the yield is dropping as it becomes more apparent that corporate issuers will survive. Corporate bonds are still offering enough an attractive yield, but doing so with less downside risk, making them a more attractive investment for conservative income investor.

“I believe that they are pricing in default rates higher than what is expected, given that we have experienced pretty extraordinary type of events, some benefit of doubt needs to be in,” Briggs says. “I think they are still pricing in too much risk especially at investment grade.”

Working bonds into the portfolio

Investors who piled into government bonds during the bond run-up of late last year did preserve capital but now they may be costing themselves excess income return by remaining there, particularly when government yields are compared to the yields on high-quality investment grade bonds, says Robert Gorman, chief portfolio strategist at TD Waterhouse Private Client Group.

“Our forecasted theme for this year in fixed income is a reversal of flight to quality, as investors become less fearful, higher yielding corporate are going to benefit,” Gorman says. “We had seen the U.S. ten year Treasury yielding somewhere in the 2% range and as of this morning (May 13, 2009) it’s at 3.12%. The 10-year Canadian bond has virtually identical yield at 3.13%.”

In comparison, he says a bond fund offered through TD’s private client group, constructed of very conservative investment grade bonds, is yielding above 5%.

“Looking at things today, I would say that for fixed income investors, high-grade corporate bonds are generally the best place to be,” he says. “It’s a pretty nice combination of factors here. You have a higher stream of income. You have a short duration which makes the bonds less susceptible to increased bond yields and the adverse impact on price that creates. All of those things are good things. We’ve been heavily overweight in corporate bonds versus treasuries since the fall.”

Don’t overpay

Of course, the market is recognizing similar advantages, so there has been a huge-run up in investment grade bond issues, Gorman says.

“In the first quarter of this year, which ended on March 31, investment grade corporate issues were US$824 billion — that’s over twice as much as the same quarter a year ago. I don’t have comparable Canadian figures, but you see all these new issues like CP Rail issue and they are all being over subscribed,” Gorman says.

Richardson Partners Financial’s Andy MacLean, director of private client investing and Clancy T. Ethans, the firm’s senior vice-president and chief investment officer, have also been advocating a higher allocation to corporates in the bond portfolio for some time.

“It’s very important to stick with quality,” MacLean says, “We’ve been looking at a lot of issues from the insurance company, the banks and some of the utilities.”

MacLean says he’s buying most of those issues for their income yield rather than trying to play an increase in valuations. It can be a difficult task since there is a propensity for investors to overpay for high-quality bonds with attractive yields right now, Ethans says.

“To pick up yield, most of the bonds are trading at a premium, meaning the coupon is in excess of yield to maturity. You can end up getting capital erosion. You buy at them at 102 and they mature at 100. That is one of the dilemmas you have in the fixed income world,” Ethans says. “We’re always in search of any bonds that are trading as close to par as we can get them.”

Attractive yields can also be found in the high yield space, MacLean points out. High yield bonds are also coming off depression scenario pricing. They do, however, remain a risky asset class.

“If you want to go out further out the risk spectrum and we have been recommending that for clients that can take on the risk, you would be looking at the high yield market in the U.S.,” he says. “They were discounting an economic scenario that worse than the reality of the great depression. Those spreads have pulled in quite a bit, but we’re still sticking with that recommendation.”

Diversify risk

There are real risks in non-government bonds, which means defaults will happen. They might not be in excess of the 20% that was previously being priced in, but clients are going to want to diversify their exposure.

“Unless an investor is familiar with issuer, and comfortable with the company it’s probably best to diversify bond exposure via a bond fund. Check to see what their selection criteria is and make sure the clearly diversifying away credit risk,” Gorman says.

Briggs adds that the risk of insolvency for some companies remains very real. He doesn’t characterize last year’s run-up in government bonds as a bubble. He believes there were (and remain) fundamentally based fears about deflation devastating the global economy.

“We are fighting to prevent to a deflationary environment. We have severe economic contractions. We have very large increases in economic slack not only on productive resources but also on employment. There is a lack of wage traction, we’ve seen some very high profile bankruptcies,” he says. “The fundamental backdrop has brought overnight rates at zero. Treasuries are likely overvalued but there is a lot of situational economics is supportive of that price. As the economy normalizes and there is an appetite for more risk, which we’ve seen. You’ll see more people move money out of the government bonds.”

(05/13/09)