A good environment for investment grade corporate bonds?
In what we expect to be a developed world of weak growth, low inflation (and possibly deflation), as well as subdued interest rates over the next few years, investment grade corporate bonds offer attractive risk-reward characteristics. Historically, they have exhibited lower volatility than ‘riskier assets’ such as commodities and equities, and default rates should be low as long as economic growth continues, even at a modest pace. Large companies, especially in the US, are generally sitting on substantial cash balances. Corporate bonds should also be supported by the search for yield in a prolonged period of low interest rates. Finally, there is the prospect of further quantitative easing (QE) by central banks, which could include purchases of corporate bonds, if deflation becomes a more serious threat.
Corporate bonds are attractively valued
One way of valuing corporate bonds relative to government debt is to look at the ‘spread’ or difference in yield between the two. On this basis, corporate bonds appear attractively priced, offering an attractive spread to government bonds when compared with historical averages.
The relatively healthy state of corporate balance sheets adds to the attraction of corporate bonds. The credit crunch and recession originated from households and financial institutions being over-leveraged. The non-financial corporate sector has generally been more cautious, having learnt its lesson from the bursting of the technology bubble.
Low inflation, with a significant risk of deflation, suggests that policymakers in the world’s major economies will keep interest rates low for a longtime, a stance that will support bond prices, which move inversely to their yield or interest rate. Low interest rates on government debt are also likely to encourage a ‘search for yield’ by investors, fuelling demand for higher yielding assets such as corporate bonds, commercial property and equities with high dividend yields.
Low rate environment expected to continue
It is not just that central bank interest rates in the US and euro-zone are currently low, they are expected to remain at subdued levels in the future, because of the prospect of weak growth and inflation. Price rises in the euro-zone and the US are already weak, with core inflation currently below 1% in both regions. In addition, unemployment rates remain stubbornly high, suggesting soft wage growth going forward, which could help push inflation down further.
Risks – double dip or strong inflation
The main risk to our positive view on corporate bonds is a sharper-than-expected slowdown in world economic growth. Our central scenario is for a moderation in global growth in 2010 and 2011 as various government stimulus measures are withdrawn, but not a ‘double dip’ recession. However, if the deceleration is sharper than we anticipate and the global economy enters a second recession, or double dip, this could lead to an increase in default rates and higher spreads. In other words, yields on corporate bonds would rise, depressing their price. But even in this environment, we would expect investment grade bonds to exhibit more resilience compared to equities and non-investment grade debt. In addition, a sharp slowdown in world growth would be likely to be met by further action by central banks to support economies, such as quantitative easing, or purchases of financial assets, possibly including corporate bonds as well as government debt.
A less likely, or outlier, risk would be that economic recovery stokes high inflation. This would reduce the real value of fixed coupon and principle payments to bondholders. However, we believe that (given the amount of spare capacity in the advanced economies), a return to strong inflation in the developed world is some way off.
Conclusion
Investment grade corporate bonds offer attractive risk-reward characteristics for investors given that we anticipate an environment of weak growth, low inflation and interest rates in the major advanced economies over the next few years. Investment grade corporate bonds can also improve the diversification of an equity portfolio as well as diversifying and enhancing the returns generated by a fixed-income portfolio composed primarily of government bonds.
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