What next for corporate bonds…
By Stephen Snowdon, manager of Artemis Corporate Bond Fund
After a tumultuous two months in markets and with corporations scrambling to fortify their balance sheets, what can we expect from corporate bonds? Stephen Snowden, manager of the Artemis Corporate Bond Fund, shares his views.
“So, we’ve had what turned out to be a brief stock market crash. We had worrying illiquidity in the bond market – even for US Treasuries until the Federal Reserve stepped in. We’ve had the expected macroeconomic implosion as first supply and now demand are severely impinged. But we also had an astonishing equity bull market in April, along with record debt issuance as corporates buttress their cash positions.
“Corporate spreads have tightened since a sharp sell-off in March.
“All of which leads to the perennial question: what happens next? It’s a question we’ve always asked ourselves but the extremity of this shock makes it much less predictable.
“I will bypass any attempts at epidemiology or comments on different government policies but be reassured we are keeping a close eye on potential outcomes. A characteristic of the recovery from the financial crisis just over a decade ago was weak demand and expanding debt. There’s no reason to assume this time will be any different."
“There has been a glut of corporate debt issuance as companies shore up their available capital. Corporate leverage has caused a hum of concern for some time now but most have waved this away, citing the low-rate environment which facilitated this debt expansion.
“New factors are the backstop on corporate bonds from central banks which, in the US’s case could equate to around one-tenth of the investment grade market."
Debt vs dividends
“The authorities are playing a greater role in markets which brings the potential for moral hazard but also disruption to the market forces which lead investors to hope that rational outcomes will always emerge. An example of this is the edict on dividend policy for many insurers. Other corporations which have had to borrow from governments have also had their dividend policy scrutinised.
“From our perspective, the dividend cuts result in stronger balance sheets, which can only be good in this environment. The dividend fallout has also served as a reminder about the merits of bonds as a source of income. Because of their position in a company’s capital structure, bonds offer a safer way to access those companies which are likely to make it through this crisis – especially those which have been issuing debt at attractive rates to ensure cash flow liquidity."
What about inflation?
“The main risk to this assumption is inflation. While demand may be weak, the sheer scale of monetary and fiscal support in response to Covid-19 would have a classical economist preparing for an attack of Zero Stroke.
“Overall, we believe inflation risk is being under-estimated and that government bond yields will probably increase. To be clear, this is a longer-term risk. But investors are currently discounting any inflation threat for the next 30 years. It could be prudent to ensure there is some protection against any inflation shocks. Our main focus for the time being, however, is monitoring how companies plan for the Covid-19 aftershocks, while taking advantage of the price dislocation that this disruption has brought."
“So, who are likely to be the winners and losers? A look at our sector positioning gives a big clue but there will always be gems and duds within each. We are underweight retailers, retail REITs, pubs and restaurants, airports, auto manufacturers, transport and oil. On the other hand, we are overweight financials, food retailers, technology and healthcare. The case for food, technology and healthcare during this period is reasonably intuitive but financials may not be. Financials are in a much stronger position than they were during the financial crisis. Basel III regulations ensured they would be more resilient in a downturn and they are more the ‘middle men’ in this crisis than the epicentre. And, while enforced dividend cuts may be bad news for equity investors, it is good news from a balance sheet perspective – and for bond holders who want a going concern to keep paying coupons and give back the principal when the bond matures.”