2023 has been a roller-coaster ride in the world of bonds with the Barclays Global Aggregate index recording its best and worst months ever by the end of February. After a tumultuous 2022, US $672 million has flowed into US investment-grade bond funds, according to Morningstar Direct with companies, in particular financials, rushing to take advantage of the demand with a record US $156.2 billion of investment-grade corporate debt issued in February 2023 alone. This brings the total to US $301.4 billion for the year to date, according to the Securities Industry and Financial Markets Association1.
Recent weeks have seen shock waves ripple through lending markets, however, with Silicon Valley Bank and Credit Suisse bringing the importance of underwriting, but also an understanding of capital structure seniority within this, to the fore. As has been written many times on this subject, this was a liquidity not a solvency crisis, but ultimately it brings us back to the core values that sit behind any bond investment given the binary nature of the return profile – how much confidence do you have that you will get your money back when your bond matures and, in the meantime, how well are you being compensated for the risk that this may not happen?
Clear objectives help in the face of extremely volatile markets
The post GFC world has seen staggeringly low defaults. On the one hand this is good, but I would argue this is not actually a normal or healthy state for the bond market to be in. This has led to a somewhat laissez faire attitude to both of these risks. We are now in an adjustment phase which I for one welcome as a long-term supporter of active fund management and alpha over beta.
At the time of writing (last week of March), the headlines are eerily quiet. It is generally assumed that we are at or near peak central bank interest rate levels, with the hope that the inflation genie is encouraged back into its bottle very soon. Spreads are sitting roughly in line with historical averages at an index level in both investment grade and high yield markets. It is difficult to argue they are the table-banging bargain that they were of a few months ago. And then we come on to the new kid on the block as a challenger to distract the eye of the investor – cash.
Cash as a challenger
I can’t deny that we as a team have been having the discussion on the merits of a higher cash level given the income that money market and even overnight rates offer. As much as anything having the powder dry to take advantage of volatility in the market and the ensuing long-term investments that cheapen up in such times seems wise. But I would counter this perspective with two points.
The first is that the index level of spread is not all that is on offer out there. A quick glance down the list of running yields – this is the actual cash payout based on a simple calculation of current annual distributions divided by the clean price – on offer within in the market are significantly higher than both the overall market level, but importantly of cash. The key here is to value the benefit of the quality of analysis that decides if this is fair, or if actually it’s a bargain. The other point to note is that there is every chance that cash rates are peaking. One whiff of a recession and the whole yield curve will get repriced in the expectation of central bank action. The gyrations of the recent past are testament to the uncertainty of the outlook in this regard, but the consistency of the higher yields on offer across the corporate bond landscape offer a welcome fillip to this.
A different proposition
If you bought a 10-year corporate bond in the UK at 5% yield for an investment grade name and we’re in that scenario where six-month paper is resetting by 50bp, I’m pretty convinced that you would find that the 10-year corporate bond you just bought would be at lower levels as well. However, if the spread on the bond also rallies by 50 basis points too due to a recognition of the quality of the company, or even just the IG market in general, that’s 10 points of capital upside, given the duration in the position, and you’ve locked in long-term yields – an interesting alternative and a totally different proposition from the last 15 years.
