24th November 2014
Ian Spreadbury, manager of the Elite Rated Fidelity Strategic Bond fund.
Global credit markets have had a strong year so far in 2014, with equity-beating returns. However, this has led a number of commentators calling time on the bond bull rally. The question for investors must be: what is next for corporate bonds? Does value still lie in corporates – and what is the outlook for yields? Ian Spreadbury, Fidelity Strategic Bond, examines:
What is the current outlook for bond yields?
We have moved into an extraordinary economic environment with bond yields close to all-time lows. A weaker outlook for global growth and inflation has quickly diffused fears of a ‘great rotation’, with bond markets continuing to reward investors. Yet, while the search for yield remains intact, investors have understandably become more cautious at these levels.
But this is not the end of the longstanding bond bull market. The sheer level of global debt is driving a propensity to save, reducing aggregate demand and keeping inflation subdued. My base case for 2015 remains an economic backdrop characterised by low inflation/low growth – nominal growth could well fall further in my view, driving bond yields down even further from current levels. I remain convinced that any interest rate hikes will be gradual in nature.
Do corporate bonds offer value?
On valuations, high quality corporate bonds still offer a decent yield pick-up over government bonds, with a current spread of around 1.4%. Considering the average loss rate on BBB-rated corporate bonds is 20 basis points per annum – with a worst ever loss rate of 40 basis points – investors are still well compensated for default risk in my view. The yield premium is also a consequence of the deteriorating liquidity in credit markets. I continue to manage liquidity at the fund level by keeping a sizeable allocation in government bonds and cash.
Is it time to move down the credit spectrum?
It is important to question whether it is worth moving down the credit spectrum to achieve a better income, given where we are in the credit cycle. In light of recent idiosyncratic events and spells of poor corporate bond liquidity, it is clear that careful issuer selection will be key to delivering attractive risk-adjusted returns going forward. At these low yields, I expect the new issue pipeline to remain sizeable and we can afford to be selective in the coming year.
Are you concerned about a bond sell-off?
All in all, I expect the search for yield to continue, and that is generally positive for bonds. I also believe the income and diversification benefits of duration still outweighs the potential for capital loss from rising yields. As the chart below illustrates, investment grade corporate bonds provide investors with a good hedge against equities and I don’t expect this to change going forward.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Ian's views are his own and do not constitute financial advice.