Fixed income investing in volatile times

Is there still a place for corporate bonds in a portfolio?

One feature of markets in 2022 was that bonds were very volatile.

And although one of the reasons they tend to be owned in portfolios is to reduce volatility, bonds suffered heavily last year as central banks put up rates in a bid to get a hold of inflation.

Amid the current volatility, what role does fixed income – particularly corporate bonds – have to play in a portfolio?

This report is worth 30 minutes of CPD.

Your view: the role of corporate bonds in a 60/40 portfolio

When asked "what role do you see for corporate bonds in a 60/40 portfolio?", 44.2 per cent of advisers said they saw no change in the role of corporate bonds, whereas 39.6 per cent said they saw an increasing role for this type of asset.

One sixth (16.3 per cent) said they saw a decreasing role for corporate bonds.

David Coombs, head of multi-asset investments at Rathbones, says: “The definition of corporate bonds is very wide. In essence, we see bonds rated A+ and above as a strategic asset class for the 40 per cent allocation, but clearly supplementary to government bonds due to the higher liquidity risk. 

“Bonds below that rating we see as a tactical asset class in the 60 per cent allocation, given the higher correlation of this group with equities in stressed markets. Therefore, the expected risk/return picture for this cohort of credit has to challenge equities to find a role in the strategy. 

“This has been relatively rare and only really been material in 2009 and 2022 for us, as during these periods spreads widened and this exposure temporarily became a more efficient use of capital.”

Coombs adds that he saw no reason for the role of corporate bonds in a 60/40 portfolio to change, as liquidity in corporate bond markets continued to deteriorate rather than improve.

He notes: “I think this is partly due to the reduction in exposure to equities by UK institutional investors in favour of bonds due to structural changes caused, in part, by regulations and the closure of defined benefit pension schemes to new joiners. 

We tend to avoid them where possible and prefer to use equities as the primary risky growth drivers.
Philip Dragoumis, Thera Wealth Management

“In our funds, as noted above, credit has seldom been an efficient use of our equity risk capital and so we’ll remain tactical and opportunistic in credit.”

Philip Dragoumis, director and owner at Thera Wealth Management, says he avoided corporate bonds where possible, preferring to use equities as the primary risky growth drivers in his portfolios.

He adds: “The role of bonds in a portfolio is to provide: 1) a guaranteed yield and hence some certainty of long-term returns; 2) a hedge in periods of intense market stress as they tend to be negatively correlated to equities; and 3) a source of some stability (although this past year has put this to the test) in case clients need to sell down a portion of their portfolio for spending purposes. 

“Highly rated government bonds serve this purpose. Corporate bonds unfortunately do not, as they come with extra risks attached, such as spread widening or default risk.

"We tend therefore to avoid them where possible and prefer to use equities as the primary risky growth drivers in our portfolios.”

Is it time for a new approach to bonds?

Amid rising interest rates and the UK government’s "mini"-Budget, last year marked a volatile period for bonds.

But as the asset class has typically been used to counteract volatility in a balanced portfolio, should investors reconsider their long-term view of bonds? Or can the volatility seen last year be considered a blip?

“Global bond markets performed horribly in 2022 as inflation has soared,” notes Chris Fleming, an investment director at Square Mile Investment Consulting and Research.

“The UK government bond market was also torpedoed by a disastrous UK 'mini'-Budget at the end of September, which saw the FTSE Actuaries UK Conventional Gilt Index plunge by 10 per cent in the course of just two days.”

Historically, the complementary relationship between bonds and equities has proved invaluable when an economy enters recession, he says.

But Fleming refers to high inflation as the “nemesis” of conventional bonds, where payments of interest and repayment of capital when a bond matures are fixed, because it erodes the value of both in real terms.

“As a consequence, bonds provided no protection in 2022 as most stock markets fell,” he says. UK inflation, for example, reached a 41-year high of 11.1 per cent in October, according to CPI.

At present it is too early to tell if the bond volatility witnessed in 2022 is last year’s story alone.
Alex Harvey, MGIM

UK inflation has begun to fall – the CPI rose by 10.1 per cent in the 12 months to March, down from 10.4 per cent in February – and the Bank of England has predicted inflation to fall quickly this year.

Headline inflation in the US and Euro area has been falling in recent months, the BoE notes, but core inflation has been more stable at elevated levels.

Lower gas prices and reduced supply chain pressures should ease global inflationary pressures further in the near term, the central bank adds.

Nevertheless Alex Harvey, a senior portfolio manager and investment strategist at Momentum Global Investment Management, says it is currently too soon to tell if the bond volatility seen last year is limited to 2022.

“Shorter-term historical measures of bond volatility have edged lower after a challenging period, particularly last autumn in the gilt market,” he says.

“The picture for US Treasuries is a little different. Volatility in the Treasury market has been trending higher for several years, with recent banking turbulence and the imminent [US] debt ceiling standoff not helping.

“The Move index – a forward-looking measure of Treasury bond volatility derived from one month options – also remains elevated, albeit down from March highs that were only eclipsed in October 2008 during the financial crisis.”

Can bonds still play their conventional role?

Mathias Neidert, managing director and head of public markets at bfinance, an investment consultancy, says that even the most highly rated corporate or government bonds do occasionally undergo periods of volatility, and even severe volatility.

“[Last year] was certainly unusual from a fixed income perspective,” he says. “Such large rises in interest rates are historically very rare.

“It is also very unusual that safer bonds would generate sizable losses during a significant equity market downturn. Some might view [it] as a failure of traditional diversification. The low historic correlation between these two asset classes represents the foundation of many investors’ portfolios.”

But Neidert says despite the events of last year, the reality is that long-term correlations between equity markets and highly-rated government bonds remain very low.

“Correlation between equities and investment-grade corporate debt has always been a little higher, but is still low,” he adds. “But low correlation does not mean ‘safe haven’ or ‘never volatile’.”

Despite describing their recent performance as “shocking”, Fleming says that bonds still have an important role in portfolios. “Indeed, the case for bonds is now actually more compelling because of their recent poor performance and the yields that are now on offer.

“This does not mean that yields cannot go higher from this point, and we still advocate that with such an uncertain macroeconomic outlook, maintaining diversification outside of just equities and bonds is important.”

But Fleming says bond markets are starting to “look interesting”, with one of the reasons being that the sterling corporate bond market now offers more attractive yields.

“The average yield of high-quality sterling corporate bonds at the beginning of 2022 was 2 per cent. It is now just under 6 per cent, and such a return is not to be sniffed at.”

Investors have become accustomed to bonds and equities being negatively correlated, but that is not the historic norm.
Jasmine Yeo, Ruffer

Jasmine Yeo, an investment manager at Ruffer, says her view is that bonds, both government and corporate, will play a different role in portfolios than they have done in recent history. “Specifically, they are unlikely to be a simple offset to falling equities,” she says.

As inflation has picked up, yields have expectedly risen, she adds, but so has bond volatility.

“Conventional asset classes – bonds, as well as equities, foreign exchange, commodities – are increasingly marching to the same drumbeat. We think that in a world of inflation volatility, it will be much harder to find offsetting assets and achieve diversification.

"There is also evidence that shows when inflation surpasses 2.5 per cent, bonds and equities become positively correlated, so they fall and rise together," notes Yeo.

"Over the past 40 years, investors have become accustomed to bonds and equities being negatively correlated, but that is not the historic norm.

“Reverting to the dynamics of a positive correlation between bonds and equities is a risk to investors. Even a marginal increase in average inflation could have a profound impact on portfolio construction.”

Yeo’s view is that the coming years will be defined by inflation volatility and higher average inflation. “For that, we will need to continue using unconventional protections – derivatives – to drive returns for investors, particularly in the markets’ most challenging moments.”

How the banking sector has affected bonds in 2023

While volatility became a defining feature of bonds last year, 2023 has seen contingent convertible ‘Additional Tier 1’ bonds re-enter the spotlight.

The downfall of Credit Suisse in March saw the write-down of its AT1 bonds, which was not long after Silicon Valley Bank’s collapse, whose UK subsidiary’s AT1 instruments were likewise written down in full.

Since the US regional banking crisis began, credit spreads have moved wider, says Darpan Harar, a portfolio manager for the Multi Asset Credit Funds at Ninety One, with the broad US investment-grade index around 20 basis points wider since March.

US regional banks are a relatively small component of the US investment-grade market at below 2 per cent, he says, although the failure of SVB, as well as Credit Suisse, led to a broader underperformance of other US and European bank bonds versus the broader market.

“We continue to find most value [in] bonds from the larger, national champion banks given their diversified funding mix, high capitalisation levels and conservative balance sheets, and believe these issuers are well placed to navigate the multitude of possible economic scenarios in the year ahead,” Harar adds.

Bevan Blair, chief investment officer at One Four Nine Portfolio Management, likewise cites how average spreads on US investment-grade credit have moved out from 130 basis points to 150 basis points, but says it is “well within the boundaries” of normal market movement.

Credit Suisse’s takeover by UBS has arguably had a bigger effect, Blair adds. “AT1 securities have seen a significant write down, and have not recovered since Credit Suisse AT1 stock was essentially deemed worthless.

“AT1 stock is still down on average between 6 per cent and 7 per cent, and while this is a recovery from a loss of over 14 per cent, it has disproportionately hit funds with overweight to this type of security.”

When might corporate bonds be right for an investor?

The initial reaction to SVB’s collapse saw investors take money out of equity and corporate bond markets and favour cash, gold and treasuries, says Tom Hopkins, a portfolio manager at BRI Wealth Management.

But he says that given the size of the global corporate bond markets and the role they play, they have a place in client portfolios.

So when it comes to weighing up whether corporate bonds are suitable for a client, what are some of the factors that should be considered?

Risk appetite: “The goal is to determine how much risk the client can, or is willing to, take when investing in bonds, and understanding that not all bond investments are deemed lower risk,” Hopkins says.

We continue to find most value in bonds from the larger, national champion banks given their diversified funding mix.
Darpan Harar, Ninety One

David Appleton, a senior investment director at Brooks Macdonald, says corporate bonds may be the right choice for clients seeking a predictable, regular income with a predictable capital return if the investment is held to maturity.

“This makes them an attractive investment option for those looking for a steady income stream. However, it is crucial to remember that the investment is not risk-free, and corporate bonds have varying degrees of asset price volatility depending on the interest rate and credit risk being taken,” he says.

Interest rate risk: Appleton describes interest rate risk as a key risk of corporate bonds. “The important thing [with interest rate duration] is the time horizon of the client.

“Many corporate bond markets have long average weighted maturities, and consequently are very sensitive to relatively small changes in future interest rate expectations.

“To mitigate this risk, advisers may suggest short-duration products, which typically involves owning bonds that mature in five years or less.”

Indeed, many discovered to their cost that they held assets with too much duration last year, says Jerry Wharton, manager of the Church House Investment Grade Fixed Interest Fund.

“Now that the interest rate cycle is nearing its peak there is less risk from this angle,” he says.

“But the best yields can currently be found from the short end of the asset class, and there is little compensation for embracing longer duration and therefore potential volatility. This might change but currently, interest rates look likely to stay higher for longer than some expect.”

Liquidity risk: Besides credit risk and interest rate risk, advisers should also consider liquidity risk, Wharton says.

“This is an over-the-counter asset class and can, and does, go almost completely illiquid in times of volatility. Credit spreads can balloon out. The consequent effect on capital values can be severe.”

When uncertainty and volatility go up, liquidity tends to go down, says Pimco economist Tiffany Wilding. “Looking ahead, we see policy-related volatility going down this year as we approach the end of tightening cycles. That contrasts with last year, which saw a large repricing for the Fed and other major central bank rates.”

Tax implications of holding corporate bonds

Tax implications will differ for each investor, but in general, corporate bonds generate taxable income and non-qualifying corporate bonds can incur capital gains tax, says Faisal Manji, a director in the global manager research team at RBC Wealth Management.

“Many bonds now trade substantially below their par value because of the rapid rise in interest rates, which creates more potential for capital gains,” he adds.

Qualifying corporate bonds, meanwhile, are not subject to CGT.

The different roles of different bonds

It is important to hold a broad range of bonds across sectors, duration, and geographies, as each can play different roles, says Kelly Gemmell, a senior fixed income product specialist at Vanguard.

Government bonds: The most highly-rated government bonds often represent a safe haven asset in portfolios, says Neidert at bfinance, providing a cushion against corrections in equity and credit markets; although their present day value can be affected significantly by movements in rates, as has been seen.

Government or sovereign bonds tend to have less risk than other asset classes as governments can print more money, says Wilding, albeit at a very high social and economic cost.

Corporate bonds: Generally offer investors a premium as lending to a company is usually riskier than lending to a government, says Wilding, but within corporate credit are bonds of differing quality.

Investment-grade: Investment-grade corporate bonds introduce credit risk, but Neidert says that highly rated credit still provides strong diversification against equity markets.

High-yield: These corporate bonds may have different roles within a portfolio, says Neidert, and depending on the approach could be risk-additive or risk-reducing.

“Where an investor is shifting from investment-grade bonds towards high yield, the objective is to take on additional credit risk in hope of improved returns.

“The exceptionally low yields for an extended period of time following the global financial crisis did encourage many investors to shift from safer fixed income towards high-yield debt.

“However, an investor may alternatively be approaching high-yield credit as a substitute for equities – a less volatile way of gaining exposure to some similar return drivers.”

With high-yield bonds being less creditworthy, investors may get a higher return as compensation for higher risk, says Gemmell, but they need to bear in mind the greater volatility and danger of issuers going bust.

“Higher yield bonds also tend to behave more like equities, meaning they are generally not as suited to providing balance in a mixed portfolio.”

Chloe Cheung is a senior features writer at FTAdviser

Attractive opportunities in the 'middle ground' of credit

While most corporate bond funds specialise in either investment-grade or high-yield securities, we believe some of the most interesting opportunities sit on the borderline between these two categories: the so-called crossover names.

Crossover credit mainly covers those bonds rated “BB” by the principal rating agencies.

These companies will usually have more debt or greater cyclicality than investment grade issuers.

The leverage ratio, which compares debt to earnings before interest, tax and depreciation, is typically between three and four times for BB-rated companies.

This segment of the market is around half of the global high-yield bond opportunity set by value and covers a range of economic sectors, including telecoms, autos, energy, healthcare, consumer products and financial services.

In general, we believe that these issuers offer reasonable risk-adjusted returns.

The average US dollar yield on global BB companies at the end of February was roughly 7 per cent.

While the BB segment is classified as non-investment grade, we believe many of these companies are quite capable of servicing their liabilities over the medium term.

Moody’s data since 1983 suggests that the average loss rate for BB issuers is small: normally less than 1 per cent a year.

Averages can be misleading, because there is variation within the group, but we consider this level of delinquency quite manageable, especially with the help of active security selection.

Defaults are not the only consideration: clearly there are other factors to consider, such as liquidity risk and downgrade risk, but generally we think BBs offer a compelling trade off of risk against reward.

In summary, we think the BB market offers a sweet spot for corporate bond fund managers where they can capture some of the yield from non-investment-grade debt, without taking exposure to as many ‘blow-ups’.

What kind of companies are found in the BB space?

Double B issuers typically fall into one of four categories. First there are fallen angels. These were once strong investment-grade companies that have dropped down to BB in recent years, such as Teva Pharmaceuticals or Ford.

Second, there are leveraged buyouts led by private equity sponsors, which would include Asda and Q-Park.

Third, subordinated financials account for a significant portion of European BB issues.

Banks often issue subordinated securities to boost their capital base.

These may have fixed term or in some cases be perpetual, loss-absorbing instruments.

The majority of large European banks will also have BB securities in their capital structures, including Unicredit, Barclays, Deutsche Bank and Société Générale.

The final category is those issuers that choose BB status, because they consider around three times leverage to be the optimal capital structure.

These voluntary double BBs do not necessarily want to be investment grade.

They seek the benefits of financial gearing, without jeopardising the future of the firm.

This is a large group within the double B segment, and includes healthcare issuers Grünenthal and Convatec.

Peter Harvey is a credit portfolio manager at Schroders