Corporate bonds: the low-risk defensive asset

The current environment is delivering high yields and attractive risk-adjusted returns in the corporate bond market. Andrew Lill explores the opportunities for investors in Australia.

Last year saw a recovery in returns for many asset classes. The worst of the global financial crisis (GFC) may well be over but with rising interest rates and the withdrawal of government stimulus measures, debate rages about the growth path from here.

In this environment, corporate bonds, particularly Australian investment-grade issues, continue to offer investors an opportunity for relatively high yields and attractive risk-adjusted returns.

Uncertainty still prevails

Moving through 2010, we anticipate a number of influences that are likely to prevent a shift towards more normal economic conditions.

As interest rate rises start to take effect, we believe the more developed countries will continue to experience steady but sluggish levels of economic growth.

And following the withdrawal of government-led fiscal stimulus initiatives, one of the biggest issues is the ability of major industrialised countries, particularly across Europe and in the US, to transition to sustainable levels of economic growth.

Avoiding risks in bond management

Government debt is not risk-free. After spending large sums to sustain banks and individuals via fiscal stimulus throughout the GFC, governments now need to raise money to support their own balance sheets.

We are already seeing an increase in government debt-raising relative to corporate bond issuance, along with a subsequent increase in yields as the risk of sovereign downgrades and extra supply is fully priced in.

Due to the inverse relationship between yields and bond prices, this may lead to negative absolute returns for some government bond allocations.

This increased issuance of government bonds in the market is being reflected in the constituents of the UBS Composite Index and other diversified bond indices.

Figure 2 shows the forecast sector changes in the standard fixed income benchmark in Australia, indicating that the massive amount of government issuance will create dangers for the unwary bond investor.

In this kind of environment, a passive approach to fixed income investing can be risky. Taking an active investment approach allows the portfolio to be tilted towards corporate debt to seek a higher risk-adjusted yield given current market conditions.

Active management allows managers to continually adjust to the relative valuation changes in order to find attractive opportunities for investors, and tends to generate the most value in markets experiencing wide dispersion in sector performance.

Active management in 2010 is key.

Why Australian corporate bonds?

Australia has undoubtedly survived the GFC relatively better when compared to its global counterparts, and is one of the few countries to have avoided a recession.

Against this backdrop, investment-grade corporates have paid down balance sheet debt and are now generating solid profits.

From a corporate bond perspective, this underpins higher security of income together with a reduced probability of default.

At the macroeconomic level the Australian economy exhibits the following relative macroeconomic advantages for bond investors:

• Australia is a strong and stable economy, and could be characterised as a ‘high-yield developed economy’;
• Monetary tightening in Australia is now well underway, responding to a bounce in economic growth (3.6 per cent and 3.7 per cent consensus growth is forecast in 2010 and 2011, respectively) and leads to the Australian monetary and fiscal position looking relatively favourable;
• Trade links to Asia give Australian public finances an emerging market character;
• Australia benefits from strong trade links to Asia, with about 75 per cent of Australian exports now going to the fast growing ASEAN region;
• The Australian bond market is growing in size;
• The Australian bond market has grown by 40 per cent ($90 billion) over the past two years. The market is expected to grow by a further $475 billion (to $775 billion) over the five and a half years to June 2015; and
• A mild recession and increasing infrastructure investment is driving bond issuance in the non-financials sector.

Credit spreads

While credit spreads have contracted from their highs during the GFC, they remain wide compared to historical levels (see Figure 3).

However caution is still required, particularly in high-yield (or sub-investment-grade) bonds, where some companies face significant refinancing risk and are vulnerable to default.

In depth expert research is crucial. AMP undertakes its own shadow rating of each security, with a limited reliance on public ratings, to help avoid the risk of defaults.

This research leads AMP to believe that investment-grade corporate bonds continue to be the most attractive sector of the market.

Infrastructure and utilities

The majority of infrastructure and utilities companies have, as a basic attribute, strong and stable underlying cash flows.

Regardless of how the economy is doing, there is ongoing demand for their assets and services, such as roads and electricity, to meet day-to-day living needs.

So the demand for infrastructure and utilities is relatively inelastic to the economic cycle.

This means they are typically conservative, predictable businesses.

These characteristics have been evident over the past few years. Many infrastructure and utilities businesses have survived the recent economic downturn and GFC relatively well, mainly due to less volatility in their cash flow streams.

This makes their debt securities a compelling proposition for corporate bond investors, since they have the potential to provide high-income stability.

Expected increase in bond market issuance

Conscious of a heavy reliance on wholesale funding and a desire to increase funding from retail markets, banks have become more selective about who they will lend to.

Consequently, bank lending rates have risen dramatically for some sectors — particularly in cases where the bank has a narrow relationship with the borrower.

In a bid to manage greater liquidity, including asset and liability requirements after the GFC, banks are looking to issue a comprehensive range of non-government guaranteed debt into the market.

This ranges from shorter-term three-year maturities all the way up to 10-year maturities.

Outside of financial sectors, sectors expected to present opportunities in 2010 include prime retail shopping centres, A-grade office buildings and Australian prime residential mortgages.

But none represent as attractive an opportunity as companies in the utilities and infrastructure sector.

Facing significant refinancing obligations, infrastructure and utilities will be forced to diversify funding sources, with capital markets issuance expected to increase in 2010.

To suit the long-term nature of their underlying businesses, infrastructure and utilities companies usually require long-term financing solutions.

Raising debt via capital markets is one of the more obvious solutions to help these companies grow and develop, and to better match long-dated assets with long-dated liabilities.

At the same time, corporates recognise capital markets are still to some extent dysfunctional, with a low level of investor confidence.

So not only will bonds need to be issued at competitive interest rates to attract investors, but the quality of debt will have to be high.

This creates great opportunities for corporate bond investors who have the possibility of locking in investment-grade long-term debt at attractive rates of income.

How do retail investors gain access to corporate bonds?

An investment environment where economic growth is neither too fast nor too slow presents a ‘sweet spot’ for corporate bond investing, particularly in investment grade bonds.

Investing in these securities via a managed fund can give investors access to a diverse portfolio. Direct investment for investors is problematic due to the over-the-counter nature of most issues.

The corporate bond sector, with duration as a buffer, forms a defensive allocation providing absolute return for all weathers within a diversified portfolio.

An allocation has the potential to provide attractive rates of regular income without the need to lock away investors’ funds for months or even years.

This makes the adviser’s asset allocation process simpler and more flexible, because funds can be easily moved to other asset classes if and when appropriate.

In summary, expectations for sectors of the bond market in 2010 differ significantly but, in AMP’s view, there has been no better time to invest in corporate bonds.

Andrew Lill is head of investment specialists, listed assets at AMP Capital.