The prospects for investment-grade corporate bonds are typically impacted by the state of global investor sentiment and the capacity and desire of central banks to cut interest rates.
And both of those factors seem to be moving in positive directions for investors in the asset class, with the Bank of England and US Federal Reserve likely to cut rates further this year, and the global economy growing.
But advisers and wealth managers looking at the fixed income universe for diversification from the exposure they have will notice a change in the composition of the index, with large US technology companies now filling five of the top 10 spots. So do corporate bonds offer the diversification potential they once did?
The starting point, says Iain Stealey, international chief investment officer for fixed income at JPMorgan Asset Management, is that: “No one is going to scream that investment-grade corporate bonds are cheap now.”
He says he does not see much capacity for spreads to compress from here.
The spread is the extra yield one receives for investing in corporate bonds, rather than government bonds, for taking the extra credit risk.
If spreads are ‘tight’ that means investors are receiving, relative to history, only a little extra compensation.
A spread compression is a reduction in the spread offered between a government bond and a corporate bond, and is a function usually of the price of the corporate bond rising by more than, or falling by less than, the fall in a government bond price.
A spread compression is good news for those that own a bond, as it should mean the price is rising.
State of the universe
Stealey says there is little scope for investment-grade corporate bond spreads to tighten from here as prices, in his view, already look expensive.
The factors that would cause spreads to widen in the investment-grade corporate bond market would be a pick-up in inflation, as that would make the fixed income from bonds less attractive, or a significant deterioration in economic conditions, as that would likely entice investors to move into a lower risk asset such as government bonds.
But Stealey’s view is that inflation appears to be under control in developed markets, which should lead to further rate cuts, and tariffs have not had the anticipated effect on inflation or growth.
For Al Cattermole, fixed income portfolio manager at Mirabaud Asset Management, “spreads are undeniably tight, being in the range of 75 to 80 [over government bonds]. For comparison, in 2005, which was a period prior to the financial crisis [when risk appetites were different] the spread was 79. But I also think it should be seen in the context of it being ‘goldilocks’ conditions right now, with low growth and low inflation.”
The anticipation of further rate cuts is impacting the investment case for parts of the investment-grade market, according to Ian Horn, a bond fund manager at Muzinich and Co.
He says investors are not getting sufficient extra compensation for buying bonds with a longer date to maturity, such extra yield is known as the ‘term premium’, but Horn notes bond prices at the this end of the market are relatively unattractive due to a lack of new bonds being issued.
Horn’s view is that companies are not issuing bonds with a longer date to maturity now as they wish to wait until base rates fall, at which point they can issue at a lower interest rate than is available now.
The impact of this, he says, is that it is spreads on bonds with a longer date to maturity that are more likely to widen — that is, for the price of those bonds to fall.
That is because he feels the lack of issuance has kept the spread on longer dated bonds lower than is justified, but that as base rates fall, companies which had avoided issuing longer dated bonds will begin to do so.
Nicolas Bickel, group head of investments within Edmond De Rothschild, a private bank and wealth management firm, is somewhat more positive on the outlook for corporate bonds.
His view is that while spreads are tight, the actual yields on offer are attractive, as the yields are now generally positive in real terms, that is, after inflation.
Bickel says the level of issuance by governments means it is those bonds that could be more volatile and could see a sell-off.
Yield hungry
So if investors with income as a priority are unable to find yield by taking more duration risk to access the term premium, the other option is to take more credit risk through buying high-yield bonds.
With investment-grade bonds regarded as expensive, is there a risk that more investors buy high yield?
Stealey says high-yield spreads are tight, “but everything is”, and at present default rates in that part of the market are low.
But where he says he is finding value is “further down the capital structure”, in what are known as subordinated bonds.
Those are bonds issued by the same companies that issue conventional bonds, but where an investor receives some additional yield in exchange for being paid only after those who own the first tranche of bonds, known as senior bonds, have been paid.
Shamil Gohil, a bond fund manager at Fidelity International, is also keen on subordinated bonds. He regards high-yield spreads as too tight and so is concerned they would be vulnerable to an economic downturn, in a way investment-grade bonds would not be.
Horn takes a slightly different view, saying the average duration on a high-yield bond has come down, which may reduce the risk and therefore justifies a lower yield and tighter spread.
This is because the time an investor has to wait to be repaid is shorter, and so there should be greater clarity on the prospects for the company involved.
Tech titans
The largest US technology companies have increased the amount of capital they need to raise, in order to fund initiatives within their AI businesses.
The impact on the bonds of those firms can be seen in the chart below, which shows those firms’ bonds typically traded at a tighter spread, and therefore a lower interest rate than the wider investment-grade market, but are now trading at the same or narrower spread.
The implication of that, says Horn, is that the market has started to anticipate the extra bond issuance by those companies and nudge up the interest rate accordingly.
But what does that mean for the investment-grade sector as whole?
Investors often allocate to bonds on the basis they are inversely correlated with equities, but if both indices have material weightings to the same technology companies, is diversification dead?
Gohil says that while the level of issuance by the individual companies is “meaningful”, it does not dent the diversification argument, as the weightings to technology in the global bond index remain very low.
He says: “The [investment-grade bond] index is $10tn in size and financials are 25 per cent of it. If you look at the big tech companies, and project forward a little bit, it could be that within a few years they have $400bn of the debt outstanding, which would be about double in three to four years. It is material but it’s not an outsized position.”
To put that 25 per cent number into context, only about 2-3 per cent of the market right now is to technology companies, though if it did get to the $400bn mentioned above, that would take it to 4 per cent.
The weighting of the big seven US technology stocks in the global index is more than 20 per cent.
Stealey says he is “not overly concerned” about the level of debt being issued by the technology companies, as he feels tech was under-represented in the index in the first place.
He expects more issuance to happen.
But he says: “The thing that could be interesting is if there were to be a major sell-off in the equity markets, would that lead to a widening of the spreads in the bond market?”
The spreads would widen if investors responded to the sell-off in equity markets by selling off the debt of the same companies in the bond markets, which would mean spreads widening.
A sell-off would not mean the chances of those companies being unable to repay the debt increasing materially.
James Klempster, deputy head of multi-asset at Liontrust, agrees.
He says: “People being worried about the tech exposure and about the fact that an investment in bonds is not a pure play diversifier any more have a valid point, as there is an argument the spreads are correlated with the performance of equities. But there isn’t any evidence that would happen.”
Klempster says the fixed income present in the portfolios he looks after is currently short duration in nature and stretched across investment-grade and high yield.
Mirabaud’s Cattermole says that the capital being raised is being used to invest in “technology speculation, and that changes the bargain between investors and those companies. It used to be the yield on the bonds of the big technology companies were low; were basically the yield on cash, plus a little bit. But that has changed more recently, with the spread on Oracle bonds widening by about 75 basis points very quickly.”
That spread widening happened after the market became concerned about the level of debt Oracle was issuing to fund its AI plans.
The price of Oracle’s shares also fell as a result of this.
Horn says the problem may come at the portfolio construction level, as most bond funds that can be accessed by UK advisers and their clients are not permitted to have more than a certain portion of their portfolios in the bonds of any one company, and that could limit demand for the bonds of the largest issuers.
But he says if the spreads continue to move as they have in the chart above, it may start to represent an opportunity for investors.
Horn says there has been a pattern recently of spreads in certain sectors widening on short-term bad news, such as those of car companies on the announcement of potential tariffs, only for the spreads to compress again when the danger was averted, generating a profit for those that invested at the time the spreads were widening.
David Thorpe is senior investment editor at FT Adviser