One of the major themes we have been talking to investors about in the last few months has been the evolution of the credit market since the onset of the global financial crisis a decade ago. It is often forgotten, for example, that interest rates in the UK stood at 5.50% at the end of 2007, that 10 year UK and Greek government bond yields were nigh on identical and that the Bank of England (BoE) had a balance sheet of just £77 billion. But what did the sterling corporate bond market look like?
Fitch data highlights that UK corporates issued just €50 billion of corporate bonds in 2007, compared to nearly €250 billion that was accessed via bank loans. This was a Europe-wide phenomenon pre the credit crisis, with loan issuance peaking across the continent in 2007/8. It is currently far from returning to its historical highs. Instead, quantitative easing has seen European corporates increase their reliance on debt capital markets for funding, with bond issuance hitting record highs in 2016 and 2017. For example, the latest Fitch issuance report shows that bonds now account for almost 50% of new corporate debt issuance. The average was 26% between 1997 and 2007 and 41% in 2008 to 2016.
Sterling corporate bonds
This trend is also evident in the UK, with corporate bond issuance rising from €50 billion to €70 billion and loan issuance falling from nearly €250 billion to €75 billion. Undoubtedly the BoE’s significant quantitative easing programme, allied with historically low interest rates have made the prospect of bond issuance more attractive and this has been reflected in the make-up of the corporate bond market.
iBoxx Sterling Corporate Bond Index: changing characteristics
Source: Markit, as at 31/12/17.
As you can see, the cost of issuing a corporate bond is significantly cheaper in 2017, with yields now below 3% in most sectors. In addition, lower rates have encouraged the issuance of more longer-dated instruments, highlighted by the average duration of the Index increasing. We have recently seen Oxford University issue a 100-year bond for example, locking in a low cost of funding. Ten years ago, when yields were north of 6%, this would not have been a popular option.
The European corporate bond market has also opened up once more to higher yielding issuers in recent years. Non-investment grade issues have been around 20-25% of total volumes since 2013, just above the levels they reached prior to 2007. Again, the UK was reflective of this trend, with sterling-denominated high yield bond issuance reaching £9 billion, its highest level ever according to Thomson Reuters. Combined with an increase in investment grade issuance, the increased diversity in the market has provided greater opportunities for fund managers. However, whilst default rates are currently very low, we should remain wary, as investors’ hunt for yield will have allowed more risky borrowers to access the markets.
How to deal with monetary tightening?
For the first time in a decade, we are at the beginning of a monetary tightening cycle. Interest rates are forecast to rise globally, which will put upward pressure on companies’ funding costs. The vast amount of monetary stimulus has been a key driver of these low default rates and this rising tide of liquidity has lifted all boats. In recent years there has been little reward for credit selection with spreads on virtually all bonds tightening. Going forward however, with the tide of money set to turn we believe that good credit selection should once again become an important driver of returns for corporate bond funds.
At Canada Life Investments, we have always managed money with a focus on strong credits and capital preservation. This was evidenced in 2008, when the LF Canlife Corporate Bond Fund returned 3%, whilst the IA Sterling Corporate Bond sector lost 10%. Indeed, only two funds were able to deliver a positive return that year.* In 2018, we believe this same focus will be critical. Although the synchronised global economic recovery should prove supportive of corporate bonds, we are cognisant that higher inflation and further rate hikes will put further pressure on fixed income prices. The LF Canlife Corporate Bond Fund and LF Canlife Short Duration Corporate Bond Fund have always had slightly defensive biases, given our long-term, sustainable focus. However, were these risks to increase, we would look to rotate some parts of the portfolios into higher credits, whilst maintaining our short duration positions.
*Source: Morningstar Direct, as at 31/12/08. Bid to bid, with net income re-invested for the C share class.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate.
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