Oak Tree Wealth Management Limited
Corporate Bond Rationale 20th May 2009
Our biggest asset class overweight compared to benchmark is corporate bonds. This is not because we view them as a risk free asset but rather because we are of the view they offer the best risk reward trade off among the major asset classes in what we view to be a world that is in the early stages of a gradual and uneven recovery from a seismic economic shock.
The two key identified risks are credit risk and interest rate risk.
Credit Risk – In the Invesco Perpetual conference call of 20.1.09 it was pointed out that Deutche Bank estimated the High Yield market was discounting a 5 year default rate of 50%. This is slightly worse than the default rate seen in the Great Depression. Whilst possible, we think that because governments around the world have acted earlier and more profoundly, that this is unlikely. Furthermore, while recovery rates in default are unlikely to be as high as the 30 to 40% seen in prior cycles, fund managers at Henderson and Invesco Perpetual are of the view some High Yield bonds are trading below what eventual recovery will be. Chrysler in the USA and the buying back of subordinated debt by banks in the UK and Ireland lend credence to this view.
Interest rate risk – Old Mutual highlighted that the long term relationship between investment grade corporate bonds yields and government gilts is a premium of 1.25 times on the former. As of early May it was still 1.70. This implies to us that there is scope for government bond yields to rise but corporate bonds can still offer decent returns as this valuation gap normalises.
We should note that the recent tightening of both High Yield and Investment Grade spreads have been from record levels and that both are currently still trading at levels associated with economic distress.
In order to mitigate risk further we have used a minimum of three Corporate Bond Funds in each of our portfolios and have varied the percentage in High Yield according to the risk profile of the fund i.e. our Growth Fund has the most exposure to this asset class. Also, we have chosen funds with differing exposure to High Yield – some, such as the Invesco Perpetual Corporate Bond has 80% lower limit to Investment Grade while their European High Yield fund is mostly lower grade credits.
Lastly, it is prudent to point out that we are concerned how quickly an overweight in Corporate Bonds has become consensus and even more so that they garnered circa 70% of UK retail inflows in Q1 2009. However, this is after a pronounced sell off and probably means investors are still nervous of equities and Corporate Bond dividends are safer.
In a decent economic recovery we acknowledge equities are likely to outperform but we are comfortable that Corporate Bonds will themselves be able to offer absolute returns of a magnitude normally associated with shares. We would rather give away this incremental upside in order to garner incremental yield and downside protection. As bad as Corporate Bonds performed in 2008, they still outperformed equities.
Likewise if inflation soars quickly Corporate Bonds will be hurt. However, they are still likely to outperform conventional gilts and property, areas where we are significantly underweight.
In conclusion we are happy to be very overweight Corporate Bonds via a diversified number of issues and bond qualities but are very aware of both credit and interest rate risk. We will, as ever continually monitor our positions and be prepared to act when the situation merits it.
Chief Investment Officer
Important Information / Risk Factors:
Past performance is not a guide to future performance, and investment markets and conditions can change rapidly. Investments in equity markets will be more volatile than an investment in cash or fixed deposits. The value of your investment may go down as well as up. There is no guarantee you will get back the amount invested. If your fund invests in overseas markets, currency movements may affect both the income received and the capital value of your investment. If it invests in the shares of small companies, in emerging markets, or in a single country or sector, it may be less liquid and more volatile than a broadly diversified fund investing in developed equity markets. The views expressed herein should not be relied upon when making investment decisions. The article is not intended as individual advice and if you require advice or further information you should contact us.
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