How NIRP is driving investors to take the corporate shilling

One of the biggest conundrums facing investors today comes in the form of the Government bond market. In theory a source of steady coupons in return for taking limited risk, this arena is now home to negative yields – which guarantee the holder a loss over the lifetime of the bond if it is held from issue to redemption. And yet the world has never been more indebted and the supply of bonds never higher.

This should be a recipe for soaring yields and low prices, not record prices and plummeting yields. Yet zero-interest rate policies (ZIRP) and now negative interest rate policies (NIRP) instituted by central banks, coupled with fears of a recession or even deflation and the short-term uncertainty created by the UK’s EU membership referendum on 23 June, leave huge chunks of Government debt offering negative yields.

The table below shows the yields on offer from seven countries across seven different maturities. It makes sobering reading for coupon-hungry investors, some of whom must be very worried about the world indeed if they are prepared to accept a guaranteed small loss (in nominal terms at least) on Government bonds rather than investigate other asset classes, such as stocks, property, commodities and cash.

Global Government bond yields are progressively going deeper into negative territory

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Equities are a potential source of dividend income, with indices such as the FTSE 100 offering a yield of more than 4% at the time of writing. Yet the potential for capital loss may deter some risk-adverse portfolio builders from getting too heavily involved, especially after  a seven-year bull run in developed markets has run into the sand in the last two years and done so to such an extent that many headline equity indices have quietly slipped back into bear market territory, more than 20% below their recent highs – Japan, Hong Kong, Italy, Spain, Sweden and China among them.

This may persuade income-hunters to dip their toes into the world of corporate bonds – in theory offering higher returns in exchange for higher risk than Government debt but lower capital upside and lower yields than equities, but with potentially less scope for damage in the form of capital losses.

There is a good selection of actively-run and passively-managed funds available to those who do not have the time or inclination to get involved with the selection of individual debt securities.

The following tables look at the best performers on a five-year view in the GBP Corporate Bond and Global Corporate Bond categories, though there are alternatives, for those investors who still feel fixed income has a role to play in a diversified portfolio.

The predominance of long-dated bond specialists is telling, as this is where capital returns have been highest, as buyers have scrambled for almost any kind of premium  coupon – and this is where the yields are highest as the risks are highest.

Best performing OEICs in the GBP Corporate Bond category over the last five years

Source: Morningstar, for the GBP Corporate Bond category Where more than one class of fund features only the best performer is listed.

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

There are also nearly 30 investment trusts dedicated to investing in debt, although not all are pure plays on corporate debt. Some specialise in the fledgling area of peer-to-peer lending and this grouping in particular has a limited trading history. The overall yield on the sector of 6.7% suggests that the investment companies as a group lean more toward the riskier end of the lending spectrum.

Top performing debt-specialist investment companies over the last five years

Source: Morningstar, the Association of Investment Companies, for the Sector Specialist: Debt Category

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

There is also a select number of exchange-traded funds (ETFs) which are designed to track or mirror the performance of baskets of corporate debt securities, and provide their total return, minus the costs of running these passive funds.

Best performing ETFs in the GBP Corporate Bond category over the last five years

Source: Morningstar, for the GBP Corporate Bond category Where more than one class of fund features only the best performer is listed.

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

In the case of funds and ETFs, there is also a small number of global corporate bond funds available, some of which provide currency hedges (into sterling, euros, dollars or even Swiss francs).

Big buyer

Now seems a particularly appropriate time to analyse whether corporate bonds may be a suitable asset class for inclusion in a portfolio, for three reasons:

• First, as outlined above, sovereign debt is offering less and less yield, even if someone, somewhere seems willing to pay for the capital protection theoretically on offer.
• Second, global inflation expectations continue to sink. The five-year, forward inflation expectation rate in the USA now stands at just 1.42%, some way below the Federal Reserve’s 2% target. Any corporate bond or fund that specialises above this may therefore catch the eye of those investors looking for some positive real yield in exchange for some capital risk.

Inflation expectations continue to sink

Source: FRED – St. Louis Federal Reserve Database

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

• Third, there is a new buyer in town, besides investors – and that is the European Central Bank. As of early June the EU’s central bank began funnelling chunks of its €80 billion a month Quantitative Easing (QE) scheme into corporate bonds for the very first time, having previously limited itself to buying just Government debt.

This final point may explain why corporations have dashed to issue paper, as there is a price insensitive buyer poised to suck up large dollops of debt. It may also explain why yields continue to fall across the asset class (and therefore prices rise), even if the market anticipated the ECB and began piling in well ahead of the June deadline the monetary authority set for itself in March.

European corporate bond yields and prices moved before the ECB began to actively buy

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Unintended consequences

The ECB’s intentions are clear enough. By buying corporate bonds, President Mario Draghi and his colleagues hope that

• Borrowing costs will fall, helping firms to service existing debts
• Firms will be encouraged to borrow
• Companies will use these cheap debts to invest and hire, giving the EU economy a boost

There can be little denying that the first goal has been achieved, with possible further reductions to come.

However, sceptics argue that the scheme is already having unintended – and potentially negative – consequences.

• American firms with European operations are taking advantage of the very low (even record low) yields on European corporate debt to issue paper. This may in the long run weaken their balance sheets owing to the increased liabilities and brings little or no benefit to the EU’s economy.
• European firms are galloping to issue paper with minimal or even zero yields. Again, this debt may have to be refinanced in the future, at less favourable rates with less-than-favourable consequences for these companies’ financial health.
• In some cases, this cheap money is not being used to invest or hire staff. It is being used to fund share buyback schemes or acquisitions, neither of which bring the economic benefits desired by the ECB.

Some investors may have their doubts about corporate debt on other grounds.

• First, some will feel yields are getting too low to justify the risks, even if corporate debt looks tempting on a relative basis against say cash or sovereign debt. Such worries will be increased by ratings agency Moody’s consistently arguing in its valuable weekly research that we are in what it calls the “later stages” of the credit cycle. Research from another ratings agency, S&P, shows that 72 corporate borrowers across the globe have already defaulted in 2016. This compares to 113 in the whole of 2015 and is the highest figure for this time of year since 2009. This may explain why the market is becoming more picky, as can be seen in the year-on-year growth trends in global investment grade and sub-investment grade (high-yield or ‘junk’) issuance – the ECB may be gobbling up bonds, but not everyone is.

Global bond issuance has begun to slow as the credit cycle starts to mature

Source: Moody’s

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

• Second, the doubters will also ponder what happens if - and when - the price-insensitive ECB stops buying and starts selling.

These are both considerations which investors must take into account before they decide whether the yields and potential capital returns provide adequate compensation for the risks or not. Some may decide that bonds are no more than return-free risk and therefore not a suitable portfolio option.

The ECB’s QE scheme suggests the market has a good underpinning for now, although it is hard to see how this can run for too long before the market comes to be dominated by this one buyer – and therefore ceases to be a proper market at all, in the eyes of some.

Relative play

The other irony of Europe’s QE scheme is that the yields available on US Government bonds (Treasuries) and US corporate investment-grade debt are higher than on their European equivalent – and with the world’s reserve currency, the dollar, thrown in for good measure.

US Treasuries offer a premium yield over German Bunds

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

US corporate bond indices offer a premium yield over their European equivalents

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Anyone who thinks the euro will come under pressure, irrespective of the EU referendum result at the end of this week, and that inflation is going to remain subdued may find this gives them additional pause for thought as to whether US debt is a higher-yielding play on ECB bond-buying that Eurozone-originated loans.

Russ Mould, AJ Bell Investment Director