This year so far has been a rollercoaster ride in the world of bonds, with the Barclays Global Aggregate index recording its best and worst months ever by the end of February.
After a tumultuous 2022, $672m has flowed into US investment grade bond funds in 2023, according to Morningstar Direct.
Financial companies rushed to take advantage of the demand, with a record $156.2bn of investment grade corporate debt issued in February alone. This brings the total to $301.4bn for the year to date, according to the Securities Industry and Financial Markets Association.
After a very lively start to 2023, March finished on a quiet note in corporate bond markets. Is this the calm before another storm?
It is not a normal or healthy state for the bond market to be in
Recent weeks have seen shock waves ripple through the lending markets. However, they quickly heeded the lessons on the importance of underwriting and the capital structure seniority within it following the Silicon Valley Bank and Credit Suisse crisis.
To echo the sentiments of many, it was a liquidity crisis, not a solvency crisis. But this raises two questions. Firstly, how much confidence you have that you will get your money back when your bond matures and, secondly, how well you are being compensated for the risk this may not happen.
Ultimately, it brings us back to the core values that sit behind any bond investment given the binary nature of the return profile.
The post-global financial crisis world has seen staggeringly low defaults. On one hand this is good, but it is not a normal or healthy state for the bond market to be in. This has led to a somewhat laissez faire attitude to both risks.
We are now in an adjustment phase, which the supporters of active fund management and alpha over beta welcome.
It is difficult to argue they are the same attractive bargain they were a few months ago
It is expected we are at or near peak central bank interest rate levels, with the hope inflation will decrease. Spreads are sitting roughly in line with historical averages at an index level in both investment grade and high yield markets.
It is difficult to argue they are the same attractive bargain they were a few months ago. However, the re-introduction of cash as the new challenger is distracting the eyes of investors.
A different proposition
If you bought a 10-year corporate bond in the UK at 5% yield for an investment grade name and we’re in that scenario where the six-month paper is resetting by 50 basis points (bps), one could argue the 10-year corporate bond you just bought would be at lower levels as well.
However, if the spread on the bond also rallies by 50bps due to a recognition of the quality of the company, or even just the investment grade market in general, that is 10 points of capital upside, given the duration in the position, and you’ve locked in long-term yields – an interesting alternative and a different proposition from the last 15 years.
Cash as a challenger
Given the income the money market and overnight rates offer, it is hard to deny the merits of a higher cash level in portfolios. Having the dry powder to take advantage of volatility in the market and the ensuing long-term investments that cheapen up in such times seems wise. However, there are two points that would counter this perspective.
The first is that the index level of spread is not all that is on offer out there. A quick glance down the list of running yields (the actual cash payout) on offer within the market are significantly higher than both the overall market level but, importantly, of cash.
One whiff of a recession and the whole yield curve will get repriced in the expectation of central bank action
The key here is to value the benefit of the quality of analysis that decides whether this is fair, or a bargain. The other point to note is that there is every chance cash rates are peaking. One whiff of a recession and the whole yield curve will get repriced in the expectation of central bank action.
The recent past is testament to the uncertainty of the outlook in this regard, but the consistency of the higher yields on offer across the corporate bond landscape offer a welcome fillip to this.
Amid the chaotic start to bond markets in 2023, the corporate bond markets continue to test investment managers. However, new investment opportunities evolve with diverse propositions emerging out of the disorderly start to the year.
Kelly Prior is investment manager in the multi-manager team at Columbia Threadneedle Investments
