At this stage of the economic and credit cycle we remain reasonably constructive about the prospects for the global corporate bond market but are taking a more defensive approach than a couple of years ago.
THE DEBT-EQUITY CLOCK IS TURNING
In the years that followed the global financial crisis credit investors benefitted from a period of improving credit fundamentals. Companies and banks strengthened their balance sheets and more recently have delivered rising profits. As we head into the second half of this year there can be little doubt that this cycle has turned. These turning points are often to the detriment of bond holders.
There are more examples of companies re-leveraging and directing cash flows to the interests of shareholders in the form of dividends or share buybacks, where previously they were employed to improve balance sheets and reduce debt. Earnings are often being used to fund expansionary mergers and acquisitions and examples of speculative bids are increasing. In the last year AT&T moved in for Time Warner, British American Tobacco for Reynolds American and Kraft Heinz tried to acquire Unilever. Although the last deal did not actually complete, it forced the acquiree to re-leverage and send more of its cash back to shareholders. As a result global corporate leverage has increased over the last few years despite strong earnings, which is classic late-cycle behavior.
DEMAND FOR INCOME WITH SOME SAFETY REMAINS A POWERFUL FORCE
The supply of new corporate bonds has been robust this year reflecting the behaviour of corporates described above. However this is only one side of the coin. Demand from a cross section of investors, both retail and institutional, has also remained heightened both in the US, in Europe and the UK, with central banks having reduced interest rates to near zero and having pursued expansionary policies that include the purchase of bonds in general and corporate bonds in particular. Hence we view the structural background as supportive for the market.
MARKET VALUATIONS LOOK REASONABLE
The spread we receive for investing in corporate bonds has reduced meaningfully since the start of last year and it is tempting, therefore, to view the market as overvalued. However in the historical context of the last 10 years corporate spreads are actually fairly close to average.
HOW WE MANAGE PORTFOLIOS
Within our own investment grade portfolios, we seek to deliver attractive long-term risk-adjusted returns, using a consistent, disciplined and active approach focused on individual issuer and security selection. Our decisions are informed by rigorous, independent, bottom-up fundamental credit research. A team of 15 investment grade analysts dedicated to this area of the market use a proprietary approach which results in a deep understanding of issuer and industry dynamics.
Each analyst researches around 30 issuers, with in the region of 470 companies assessed by the team as a whole. The research team provide performance recommendations, ratings based on forward-looking credit quality expectations and a risk score for each company. They then work in collaboration with a team of six portfolio managers on investment decision-making and portfolio construction.
The investment grade team are also able to leverage the wider resources of the Columbia Threadneedle Investments’ fixed income and equity groups, giving us insights into all major fixed interest asset classes and geographies. We believe this cross-fertilization of ideas enables a deeper understanding of industry issues and provides the portfolio management teams with a well-informed investment perspective as they make relative value assessments.
SHIFTING OUR ALLOCATIONS AGAINST THIS BACKGROUND
So, where are we finding the most attractive opportunities now, and how are we positioning our portfolios in this late stage in the credit cycle? It is now just over three years since we launched the Threadneedle (Lux) Global Corporate Bond Fund. The evolving nature of the portfolio’s construction since launch gives a practical insight into our thinking.
When we launched the fund in June 2014, banks were a big theme in the portfolio. At the time, banks around the world were still being forced by regulators to build capital, improve liquidity and run down bad assets. This trend has largely come to an end. This does not, of course, mean we are predicting another banking crisis since banks are now in sound shape in most countries. However, the direction of travel with respect to credit quality has turned at a time of less attractive valuations and this has led us to take a more neutral view on the banking area of the market as a whole. At an industry level, as the credit cycle has matured, we have moved more of the portfolio into more defensive, less cyclical sectors such as regulated utilities. Presently, for example, around a quarter of the risk in the portfolio is now achieved through investments in regulated utilities and infrastructure issuers.
The credit cycle is certainly turning and corporate bond spreads are somewhat less attractive than they were 18 months ago. However investor demand remains robust and the ongoing provision of ultra-loose monetary policy means that corporate bonds will remain a cornerstone of investors’ portfolios for some time.
We have adjusted the construction of our portfolios to reflect this new reality but remain reasonably constructive about the prospects for the asset class into the end of this year.
Alasdair Ross – Head of Investment Grade and Senior Portfolio Manager, EMEA – Columbia Threadneedle Investments