By Simon Mumme
In the 2011 summer, Chris Bowie sold his home in Lanarkshire, a county east of Glasgow in the Scottish lowlands, and invested the proceeds in the corporate bond fund he manages for Ignis Asset Management. The move was timely. Seeking yield, investors worldwide drove a rally in US, European and Asian corporate debt that later amassed to $3.29trn in bond issues for the year.
“We’re sitting on the fence so much that it’s beginning to hurt.”
David Lloyd
One year later, Bowie grew bearish and shifted his savings into a new Ignis credit strategy with zero duration. In other words, he wanted to protect his money, and the €40m in company seed capital, from an imminent rise in interest rates and consequent fall in bond prices.
“My gut feeling is that it will happen in the next year or so, but it could be in five years,” says Bowie, who oversees £13.3bn as head of credit at Ignis in London, about the likelihood that central banks will lift interest rates from historic lows. “The upside is now limited for bonds so you won’t lose much by being ahead of this trade.”
Near-zero cash returns and crowded government bond markets have spurred investors worldwide to seek higher yields from corporate debt. In 2012, companies in the US, Europe and Asia sold $3.94trn in bonds, according to Bloomberg News. Since 2009, $14.34trn has been issued worldwide. Demand from pension funds, insurance companies, mutual and exchange traded fund investors has enabled companies worldwide to take advantage of record-low yields, such as the unprecedented 3.27% reached in late December, to refinance through investment grade and high yield bond issues.
Some investors now question whether heavy issuance, investor enthusiasm and low yields have fomented a buying spree typical of an asset bubble. “There is some asset bubble mentality in the herd-like behaviour of investors buying yield irrespective of credit quality and liquidity,” says Owen Murfin, managing director and senior portfolio manager in Blackrock’s fundamental global bond team.
He is not alone. In a December poll conducted by the CFA Institute, a global association of investment professionals, 18.54% of respondents said the high yield debt market was inflating into an asset bubble; 6.28% said investment grade bonds were also greatly overvalued; and 8.77% said that no fixed income markets had entered bubble territory.
David Lloyd, head of institutional portfolio management at M&G Investments, which oversees £124bn in fixed income assets, says the debt fervour is not reminiscent of the blind demand for securities seen in past asset bubbles, such as late 1990s boom in US technology stocks. “There is no definitive way of knowing if you are in an asset bubble. They are usually only evident after the event,” Lloyd says. “We are in the final stages of a long rally – not some kind of mania.”
Rate risks
Fears of a bond market sell-off triggered by rising interest rates compel Bowie to own securities with shorter duration. Speaking in December, the London-based manager says corporate bonds then offered an average 2.08% more than the 1.88% yield of 10-year UK government bonds, or gilts. This 3.96% yield is not much greater than the current 2.7% rate of inflation tracked by the consumer price index. Most of the return of bonds with duration of seven-to-eight years would be “wiped out” if gilt yields rose by 0.50% within this time frame, Bowie says. “I’m worried about the government bond market selling off and taking the credit market with it. You could see a mass exit.”
Fitch Ratings also calls for caution. If official interest rates reverted quickly to the levels of early 2011 – a rise of 2% – a typical US investment grade corporate bond with a 10-year maturity could lose 15% of its value, the credit ratings agency said in a research note last December. Such fears are premature, says Mark Wauton, who oversees £12.5bn in credit funds at Aviva Investors. Higher short-term interest rates seem unlikely given the actions of prominent central bankers: Mario Draghi, president of the European Central Bank, promised in July 2012 to do “whatever it takes” to preserve the euro, including suppressing borrowing costs; the US Federal- Reserve has committed to buy $45bn of Treasuries each month in 2013 to help stimulate the world’s largest economy; and Mark Carney, governor-elect at the Bank of England, flagged in late 2012 that he may prioritise job creation when he starts work at Threadneedle Street this summer.
“I don’t see any evidence – anywhere – saying that interest rates will tighten. This low-yield environment is going to stay for the foreseeable future,” Wauton says.
Liquidity risks
Investors in high yield and emerging market corporate bonds will have difficulty unwinding positions if a spike in interest rates or defaults causes a sell-off, says Murfin, who manages $8bn in credit mandates at Blackrock in London. “An unintended consequence of quantitative easing is that investors take more credit and liquidity risk,” he says. “This is most prevalent in Asia, where we see a huge allocation to riskier types
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