Falling interest
At Momentum we have significantly reduced allocations to corporate bonds in our portfolios over the past year. This isn’t because we expect an imminent downturn, but instead reflects the asymmetric profile we see from these levels with very little upside potential and meaningful downside risk.
In a few weeks the Bank of England (BoE) is widely expected to increase interest rates, for only the second time in the last decade. The US Federal Reserve is considerably further down the line having already made seven increases in the past three years; at some point the BoE may need to play catch-up. Political uncertainty in the UK has been holding the economy and interest rates back but with economic data rebounding recently it is now highly likely that rates will be above the current level of 0.5% by the end of the year. The Eurozone is likely to be in a similar position next year.
The recent era of ultra-low interest rates and quantitative easing (QE) has been painful for those reliant on income from their savings. However, those with holdings in fixed income securities have probably benefited from an offsetting increase in the capital value of their portfolio (since falling interest rates increases the price of fixed yield bonds). The risk is that this process may be beginning to move into reverse, albeit slowly. Investors are likely to begin seeing higher yields and distribution rates on their investments but capital values may fall if interest rates move up faster than expected.
In the UK, corporate bond funds represent one of the largest fund categories according to Investment Association data, with assets under management of ￡70 billion as of May 2018. This category is equally swollen (if not more so) outside of the UK and is one of the areas where the risk of disappointment is arguably greatest over the next few years. The current sterling corporate bond index yield of below 3% barely compensates investors for the current inflation rate, let alone any risk that inflation moves higher from here or for future defaults. Furthermore, the credit quality behind corporate bond yields has deteriorated in recent years as companies have taken advantage of low interest rates by increasing borrowing, leaving them with lower quality balance sheets and somewhat higher default risk.
Despite interest rates being at rock bottom levels for most of the last ten years, the sterling corporate bond index has returned 7% per annum. This will not be the case for the next ten years, especially if base rates move anywhere close to the highs of the last cycle of 5.75%. We do not expect this but the point is that the risks are asymmetric from this point. The pricing of European corporate bonds makes even less sense with yields below 1% still, driven by the European Central Bank’s QE programme.
Those in need of a steady income stream should consider a portfolio that is well diversified across different asset classes. There are many other investments that can improve the overall yield of a portfolio whilst arguably reducing the risk profile through diversification. This would include emerging market bonds, asset backed securities, listed property or infrastructure or even high quality equities. Each carry their own risks in isolation but we believe a carefully assembled portfolio would be much more robust in a range of scenarios than an overvalued corporate bond portfolio at this point.
Andrew Hardy, CFA