Are corporate bonds the winners of the current crisis? It’s not quite as easy as that, but there is something to it. At least one thing is certain: At a time of historically low interest rates and .…
extremestock market volatility, the corporate bond market harbours particularly attractive opportunities for investors. Even the issues of solid companies currently offer compelling yields. Investors hoping to profit from these high spreads should closely monitor sectors and issuers to minimise the risk associated with such an investment.
In 2008, a year marked by historic events (e.g., Bear Stearns, Lehman Brothers, FannieMae and FreddieMac, AIG, Iceland, RBS, HBOS, HypoRealEstate, Fortis), capital market developments, in particular, were dominated by one trend: a flight to quality.
Massive inflows into government bonds pushed yields to historic lows. The extreme risk aversion dealt a particularly heavy blow to all riskier asset classes – from equities and high-yield bonds to bank notes. Persistent economic concerns and deflation fears caused a massive sell-off on stock markets and prompted unprecedented rescue programmes.
At the start of the year, investors faced a choice between a safe, extremely low-return investment in government bonds and a bold bet on a stock market recovery. While equity valuations had reached fundamentally favourable levels, investors had to reckon with further losses and the real risk of a dilution of their investment through partial nationalisation. This dilemma focused investors’ attention on a market segment that seems to offer the best of both worlds – corporate bonds.
Here, historically high spreads compensate for generally low interest rates, and the attractive return markedly exceeds anticipated dividend yields. While equities are losing support, debt investments gain favour.
Depending on the sector, the issuer and the maturity of the issue, spread concessions of 2 to 5 percentage points over government bonds have been and still are fairly common. In this manner, companies with solid credit ratings have been able to circumvent the banks’ lending restrictions, albeit at the price of very high issue premiums.
The following table provides an overview of selected new corporate bond issues launched in 2009, including the issue spread as well as the spread performance versus the benchmark since launch.
However, this performance does not generally apply to all sectors, maturities or currencies. Continued weak economic data and more large-scale state interventions in the shape of stimulus programmes, equity injections or guarantees have fuelled scepticism over the likelihood of an imminent economic recovery. Naturally, this has also impacted corporate bonds’ secondary market spreads.
Investors should understand and be aware of the risks associated with such an investment – a point that is illustrated by two events which sent shock waves through the corporate bond market: The first was Deutsche Bank’s decision in mid-December 2008 not to call a subordinated floating-rate bond. Its move prompted a sell-off of this asset class as there was a long-held belief in the market that issuers of lower-tier paper would always call the debt before maturity, with prices or risk premiums calculated accordingly. Spain’s Banco Sabadell also chose not to call a note. Both measures, albeit economically sensible, prompted a substantial revaluation of this lower-tier bond segment in reflection of growing uncertainties over redemption dates. As a result, already issued notes plummeted and the new issuance of these near-equity products became close to impossible.
Another event with serious consequences was the British government’s decision to allow newly nationalised Bradford & Bingley to delay coupon payments on a subordinated bond contrary to the arrangements laid down in the issue prospectus. Such a retrospective revision of covenants means that investors in bonds issued by companies that depend on state assistance or are de facto state controlled face the risk of degradation. Even though the above issuer made every effort to preclude the exercise of this option, the market reaction was unequivocal.
State-guaranteed bank notes are another fixedincome segment that has emerged in the course of the crisis. These bonds were supposed to make it easier for financial institutions to raise funds and prevent a credit squeeze. Despite varying countryspecific types of guarantees, which detracted from the comparability of these papers, guaranteed bank bonds were initially snapped up by the market as they offered an attractive yield compared to the guarantors’ own bonds (e.g., the Commerzbank bond was issued at a spread of 1.21% above the comparable German government bond). Tremors emerged only when a flood of new issues threatened to drown demand and the creditworthiness of several countries deteriorated dramatically in the course of the Eastern Europe crisis – events that also pushed up the secondary and primary market spreads of state-guaranteed bonds.
The first state-guaranteed bond issued by Austria’s Kommunalkredit was launched at 50 bps on midswap in January (maturity of 2 years). After an interim tightening to +30 bps, the spread has now returned to slightly above the issue spread. Another bond of the same issuer was launched at 85 bps on midswap in March (with a term until 2012).
Conclusion
The corporate bond market offers attractive investment opportunities that compare favourably with dividend yields. Nonetheless, investors should be careful in their choice of sector and issuer and closely examine the bond covenants.
First among the sectors that currently offer both the best opportunities and the highest risks is the financial sector. The prominence of high individual risk (e.g., AIG, Citigroup) in this sector is not only reflected in share price trends, but also in bonds, particularly subordinated notes. Key risks include state interventions, potential losses and suspended or delayed coupon payments (e.g., Depfa Funding IV, BayernLB). In this environment, a thorough analysis of potential investment candidates and ongoing monitoring of investments are the key to success.
Friedbert Mueller, Product Director, Invesco Worldwide Fixed Income
Source: Trading Ideas ETF: Ideas and Flows – Deutsche Bank AG
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