Long-term investing in bonds

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01 August 2017

Fixed Income Credit: in it for the long run

In this very low yield environment, investment grade corporate bonds can be an attractive prospect for investors. When considering the overall yield available from a typical corporate bond, it becomes clear that the proportion which comes from credit spread (as opposed to the underlying government yield) has been increasing in recent years, and is now significant1. This market development can help mitigate the effect of a rise in interest rates on a credit investor’s total return.

Looking to the immediate future, the low interest rate trend shows no sign of abating, with central banks across the world continuing to implement their Quantitative Easing programmes. This means investing in corporate bonds can still provide clear scope for increasing the yield of an investment portfolio. Additionally, the growing importance of spreads as a percentage of yield makes intelligent risk-taking an easy way to add value.

Dealing with a difficult backdrop

The credit cycle is approaching its end and transaction costs are currently very high – this, taken at face value, sheds a negative light on fixed income. But by turning their backs on the asset class, investors could be missing out on an opportunity. If you drill down to specific issuers and take a long-term approach, you can still capture interesting returns in corporate bonds, under the condition that risks are properly managed by professional investors with strong capabilities in picking names (Credit Research) and constructing portfolios (for diversification and limitation of risks linked to benchmark indexing). Diversification in particular is extremely important and we caution investors against the pitfalls of following market-cap weighted benchmark strategies too closely.

The prevailing combination of pressure imposed by central banks on rates and the related search for yield, mixed with relatively good fundamentals for large companies, creates an ideal environment for investing in corporate bonds. But how to appropriately take risk and capture returns is where the picture becomes more complex, as we grapple with structural changes. One way around this is to place greater emphasis on the risk/return proposition and the implementation of diversification. A prudent, long-term, fundamentally driven approach, which limits risk taking, is how we see value being added to investor portfolios.

Tackling high transaction costs

The Global Financial Crisis (GFC) unleashed a range of regulatory reforms on banks, including Basel III, the Dodd - Frank Act of 2010 and the Volcker Rules on proprietary trading.

Traditionally, fixed income markets have been structured as over-the-counter (OTC) markets with banks acting as market makers or dealers. As dealers, they have been the ones providing liquidity by warehousing corporate bond inventory when buyers and sellers are not immediately available to settle a transaction. This has ensured the stable functioning of corporate bond markets.

But the recent regulations mean banks face a requirement for greater capital and liquidity, so they are unable to maintain large inventories of corporate bonds, and market making in this sphere is no longer as lucrative for them. A majority of the corporate bond inventory has therefore shifted from bank balance sheets to investors. This means banks are unable to be efficient market makers – leading to lower liquidity in the system as a whole, which in turn increases the transaction costs of trading.  As a relative measure, transaction costs have also become a larger proportion of the yields available.

From investors’ point of view, minimising transaction costs has become a key consideration in managing credit portfolios.

1 Source: AXA IM, As at 30 June 20107, more than 40% of the overall yield of the broad Global Credit universe (as represented by the BofA Merrill Lynch Global Corporate Index) came from credit spread.