Following a prolonged stretch of exceptional performance, corporate bonds are enduring their first meaningful decline since the tail end of the 2008 financial crisis. US and European high yield bonds fell some 2.5% in September, driving performance into negative territory recently.
While talk of disappointing returns seems to be flavour of the month, the rout afflicting the corporate bond market begun over a year ago, as the tumbling oil price triggered a wave of defaults within the US energy sector and drove yields from a historic low of 5.6% in June 2014 to almost 12% today.
More recently, mounting concerns surrounding the trajectory of US interest rates have spooked investors. This has spurred outflows from mutual funds at a time when companies are issuing record levels of debt. This combination of dwindling demand and deteriorating credit quality suggests that corporate bonds may continue to underperform, despite yields in certain segments now offering good value.
Corporate debt has been a one way bet since the end of the financial crisis, with good and bad credits alike benefitting from the insatiable appetite for yield. During this period, traditional credit research provided only modest value as strong demand from both retail and institutional investors drove yields to record lows. After all, a rising tide lifts all boats.
Looking forward, company fundamentals will be a more significant driver of bond performance, as fund managers are forced to navigate more volatile conditions and potential outflows from the sector. In such an environment, relative value strategies, such as a long position in one company versus a short position in another, will become increasingly useful.
Credit derivatives will also become more important in adding value, as well as shielding against potential losses. The cost of insurance via credit default swaps (CDS) has fallen steadily since the end of 2011, resulting in historically steep CDS curves. The cost of short-term insurance relative to longer-term protection is cheap, creating opportunities.
The CDS curve trade seeks to exploit this situation, where protection of differing maturities is bought and sold simultaneously, providing exposure to the underlying corporate for a specific period of time. Such trades earn an investor the spread between the two insurance contracts and make sense when the distribution of a company’s debt suggests a default is more likely during a certain period of time, or a specific future event, for example a court ruling, could dramatically increase / decrease the chance of default.
In some instances, this spread between two insurance contracts can be many hundred basis points, with the worst case scenario, a default, having only a small impact on performance as protection has been bought and sold on the underlying credit. The best case scenario is where the underlying company’s credit quality is seen to improve. In which case, there is no default against the protection bought, while the protection sold earns a (potentially high) yield and becomes profitable to buy back.
Market volatility remains high, with the recent situations at Volkswagen and Glencore damaging both confidence and performance. Volkswagen was a beneficiary of quantitative easing (QE) – it was a well-owned issuer and considered a safe haven investment in times of low yield. It’s also an example of where QE has forced asset prices (and investor complacency) up, with little or no benefit to the real economy.
Fund flows are also likely to be a significant headwind in the near-term. Liquidity is another factor, with the corporate risk that bank counterparties can take onto their own balance sheets dramatically reduced under new regulation. Data compiled by the Fed suggests that in the US this figure has fallen almost 90% since the 2008 crisis. This has occurred at a time characterised by some of the biggest bond issues in history and has resulted in a widening of bid / offer spreads, limiting the appeal of trades with only modest upside potential.
Looking ahead, we believe that the corporate bond market will continue to be an attractive space for investment opportunities, but the method of extracting value needs to change. In short, an old school approach will be necessary to extract value from a modern market.