Debt market specialists have been banging the drum on this for months: bonds are back.
Now it appears this message has cut through sufficiently clearly — particularly on corporate bonds — that the popularity of the bet is one of the few things they think could hold the asset class back, at least in the short term.
Financial markets had a pretty awful run in 2022, of course, both in equities and debt. Corporate bonds in the US lost about 14 per cent over the course of the year, according to data compiled by ICE and Bank of America, and that is the safe, generally even (whisper it) boring investment-grade paper — not the risky high-yield stuff often impolitely referred to as “junk”.
But the grim performance in price has jacked up yields to some of the highest levels investors have seen in two decades. Euro-denominated corporate bonds entered 2022 yielding about 0.5 per cent. Now investors can get more like 4 per cent. That’s still less than inflation, sure, but it’s a serious improvement, and it means buyers are getting as much return now for safe, steady investment-grade debt as they were a few months ago on racier, more default-prone high-yield paper.
“Mid single-digit returns in fixed income? That’s good enough,” says Tatjana Greil Castro, co-head of public markets at credit investment house Muzinich & Co, who turned more positive on this asset class in September last year. “If you want high single digits or if you’re lucky, double digits, you go into equity markets.” As a result, she no longer feels the need to stray into shakier companies, or in to longer-term debt with greater sensitivity to benchmark interest rates, to grab decent yields.
“Taking very modest risk already makes the end client happy,” she says. “Investors don’t say ‘go and shoot the lights out’. They want steady returns.”
Specialists are suddenly finding themselves in demand. The much higher yields now available have “got people talking again”, says James Vokins, who runs the investment-grade team at Aviva Investors. “‘Sweet spot’ is the right word for now,” he says, with new clients looking to shelter from the madness of equities or take on some credit exposure without the white-knuckle ride of more default prone high-yield debt.
No sweet spot lasts forever, of course. One reason for caution is simply that everyone suddenly seems to love corporate debt. The supply of new bonds on to the market is strong enough to mop that up for now, but portfolio managers say they are a little nervous that it could start becoming a crowded bet.
Vokins at Aviva also warns that investment-grade debt is priced for perfection, not for any hiccups, which could come in the form of further wind-downs in bond-buying programmes and other liquidity measures from central banks later this year, or from what is expected to be very large volumes of government debt issuance in the coming months.
“We are quite hastily moving towards pricing in a lot of good news,” he says. “When you manage a large portfolio you have to be ready for that next move — we need to be very mindful of that and approach markets slightly more cautiously as we move through the year.”
Still, some big shifts in asset allocation look set to provide long-term support. “It really does come down to the fact that over many years there’s been a broad-based reallocation away from public markets towards private markets and equities by institutional investors because public fixed income markets simply weren’t yielding enough,” says Sonal Desai, chief investment officer for Franklin Templeton Fixed Income. This has left many of those big investors with exposures to the asset class that are low by historical standards.
Now, she says, buyers of investment grade can expect to earn a yield of about 5 per cent, and the big shift back into this type of debt has further to run. “I think that’s the story,” she says. “In a sense it’s going to be a bit of a rocky ride, this reallocation, but it has to happen.”
Another allure for Greil Castro at Muzinich, aside from signs of steady improvement in the eurozone economy, is that even if she buys debt at 90 cents on the euro, say, she is pretty confident she will be paid back the full 100 cents when the debt matures, barring a truly catastrophic recession. Corporate balance sheets are in good shape thanks to all the cheap borrowing they did in the immediate aftermath of the Covid outbreak.
So if you stick with relatively short-term debt, “your relationship with the market becomes less and less important”, says Greil Castro. “After all the turmoil I think a little bit of respite is quite appreciated.”
That makes this feel like a snug place to be. “If you have volatility but you start with a [yield] close to zero then clearly you feel it, a lot,” says Greil Castro. “If you were to run out naked in the cold you will feel it but if you go out with a warm winter coat then you can sustain it much better. Now we have a warm winter coat and boots on for bad weather so we’re well prepared.”