Jeremy Sterngold, Deputy Chief Investment Officer
Bond yields across the world rose quickly as central banks stepped up their rate hiking cycle following the Russian invasion of Ukraine. As this followed a series of supply chain shocks, primarily driven by pandemic containment measures, a meaningful response was needed. While the rise in energy and food prices generally depresses real incomes, given the tight labour market, this increases the risk that wages chase price pressures. Looking at the upcoming rail and nurse strikes, it is very clear how big of a challenge this is. Hence it is easy to see how this could make inflation more persistent which may then risk an even more aggressive policy response.
So, while this year has been rather difficult for both bond and equity investors, are there any opportunities that have come as a result of this rapid reversal in monetary policy?
As someone who has managed corporate bond portfolios in various capacities for the majority of their career, the current situation for investment grade corporate bonds is worth digging deeper into. Going back through the history of market, the conditions that are present today to my mind are unique. While we have seen very steep rate hiking cycles in the 1980’s, back then the investment grade corporate bond market (as per the ICE BofA US Corporate Index) was a mere $200bn relative to $7.5 trillion it is today (approximately). Therefore, the impact of the rising rate cycle is more significant and the investable universe is much larger.
Furthermore, the start of an interest rate hiking cycle usually marks a sign of the economy recovering. This usually leads to the yield premium demanded for investing in corporate bonds, or spreads, compressing relative to sovereign bonds as businesses tend to do well in that phase of the economic cycle. This time around, the central banks are hiking as economic momentum is weakening. On top of that, central banks are unwinding some of their purchases that they undertook during the pandemic to support the economy. This has led to spreads widening at the same time that interest rates have been rising for most of the year. As bonds have been issued with extremely low coupons in the aftermath of the pandemic, this means that a lot of corporate bonds are trading below their notional value.
Dusting off the old textbooks by recapping on some bond theory using a basic example, if an investor wanted to buy a bond for £100 maturing in three years’ time with a 5% coupon, they would receive £5 in the first two years and receive £105 upon maturity. Given we are talking about corporate debt, one needs to consider the probability that a company defaults on the bond and what bondholders would be expected to receive in that scenario. That is where the current opportunity set is rather interesting. As a bondholder, you have a claim on the £100 of bonds outstanding in case of default, even if the bonds are currently trading at £70. If we were to assume that the company would return 40% of the value to bondholders in the worst-case scenario of default, generally a very small probability for investment grade bonds, this means that real downside for certain bonds are lower than the cycles we have seen in recent decades. Looking at the domestic example, the National Grid Gas PLC bond maturing in January 2033 with a coupon of 1.125% is currently trading at an indicative price below £70 per 100 notional. The spread you tend to get tends to rise with the risk of default. However, for low coupon bonds trading at these levels, comparing historic spread levels for similar rated bonds might be not as useful. One could argue given the more limited downside risk, spread levels are perhaps overcompensating investors. As such, constructing a portfolio targeting these bonds maybe a very sensible strategy given the current outlook.
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