05 Mar 2021
Roger Webb & Adam Walker, Investment Directors, Aberdeen Standard Investments
2020 saw returns of almost 9% from sterling Investment Grade bonds. This was quite a turnaround from March of last year, when coronavirus fears peaked and performance was the weakest since the global financial crisis. But with bond yields now close to 10-year lows, where do we go from here?
It’s certainly harder to argue that there is good value at current prices. However, with an improving economic backdrop, we do see room for further gains from here. We can also expect to see further gains in BBB rated bonds as credit positions improve and investors seek higher yields. The ‘spread premium’ (the additional yield over the risk-free rate) in all corporate bonds is made up of three elements – default risk, liquidity premium and volatility premium. The insatiable appetite of insurance companies for ‘high quality’ (A-/A3 rated) bonds has pushed their yields down to extremely low levels. As such, current spreads in higher quality bonds probably compensate us for default risk and little else.
Given this outlook, we are changing our fund positioning, but without increasing overall risk. We are doing this by adding to both higher conviction areas among BBB rated bonds where we see good value and government bonds to offset the increased overall risk. At the same time, we are reducing those better rated corporate bonds and sectors where we think value is less compelling.
Very short maturity bonds (1-3 years) have limited appeal given expected returns from current levels. In addition, they don’t provide instant liquidity to enable us to take advantage of any weakness and volatility. Likewise long maturity bonds don’t look attractive – money lent for long periods should give better returns!
Banks have spent the last 12 years improving their balance sheets and building their resilience to financial shocks. While bank debt sold off in the first quarter of 2020, it has now recovered substantially. Essentially, bank bonds were attractive in 2020 but feel less so in 2021. One area we do prefer however is subordinated bank debt. As the name suggests, this is riskier compared to senior bank debt as it has lower priority, which means yields are higher. While valuations of subordinated bonds have also recovered quite a bit, they still look attractive when compared to similarly rated (non-financial) corporate bonds.
Subordinated bonds issued by Investment Grade, non-financial companies are called ‘corporate hybrids’. As these bonds have lower repayment priority compared to senior bonds, they have higher yields to compensate. In the current very low yield environment, we like corporate hybrids because of their higher return potential. However as with subordinated bank debt, selectivity is very important. Having lower repayment priority further underscores the need for being sure of the credit standing and business outlook for companies. In this regard, it helps that some of the biggest corporate hybrid issuers tend to be from stable sectors such as utilities and telecoms.
As one would expect, certain sectors have been more heavily impacted by virus restrictions than others. Airlines, hotel groups, airports and public transport names all lagged the wider market for much of last year. The vaccine announcements in November helped them to catch up, but they still look attractive compared to similarly rated bonds from other sectors.
We particularly like some public transport names as they have benefited from on-going government support. This has reduced their costs, with an immediate positive impact likely when lockdowns are eased. Airports in particular are fairly unique infrastructure assets, with more limited risk thanks to frequent public ownership. For example, only 6 out of 20 of the main airports in Europe are in private hands. More risky given the ongoing move to online shopping, a trend which lock downs have accelerated, are traditional retail-related bonds. Examples of this are real estate investment trusts (REITs) such as Hammerson and NewRiver.
Another area where we see some relative value is in higher quality high yield bonds. We expect some of these bonds to become valued more like BBB rated credits, which is the lowest part of the Investment Grade market. Such bonds also tend to be less sensitive to moves in government bond yields.
While valuations are no longer as attractive as at the start of 2019, the economic outlook is better given the expected strong recovery from the coronavirus shock.
While valuations are no longer as attractive as at the start of 2019, the economic outlook is better given the expected strong recovery from the coronavirus shock. As such, with interest rates also remaining low, further gains should be achievable as economic data improves. However, periods of increased volatility are likely to persist. For example, less positive coronavirus developments such as new vaccine-resistant strains would certainly be bad for sentiment. For increased flexibility and to protect against volatility, we have increased fund weightings in cash and gilts.
To summarise, investment grade bonds are no longer cheap but have some continuing attractions. The extra yield compared to gilts is at 10-year lows, but partly this is for good reasons such as very low inflation and low interest rates. Furthermore, we expect 2021 will be a year of strong economic and corporate recovery from the huge coronavirus shock of 2020. In this context, while it would be unrealistic to expect huge returns, selectively we think further gains should be achievable.
RISK WARNING
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.