Bid fever raises corporate bond risk
Credit selection will become increasingly important for corporate bonds, and within investment grade, it will be a case of trying to avoid the names where significant structural change to balance sheets is likely to occur.
For some while we have felt that the corporate cycle was turning, with companies increasingly favouring shareholders over bondholders, now that significant levels of corporate debt have been paid down or refinanced at lower rates of interest. The progressive increase in M&A activity is evidence of this and is also a trend we see continuing into 2006.
In the current climate some of this activity will continue to be debt funded, as it remains cost effective to issue new debt with interest rates remaining low and balance sheets capable of withstanding the additional leverage. Such moves, though, are often not good news for bondholders as they increase credit risk.
However, within high yield the position will be more balanced. M&A activity will see some companies increase debt levels - impacting on risk - while others will be taken out by stronger more stable competitors and therefore see an improvement in the credit outlook for their bonds. Here it will very much be a case of trying to identify the winners and losers.
Increasing borrowings should also see an increase in new corporate issuance from the very low levels of 2005. The market should be capable of absorbing the higher level of issuance through strong demand from investors globally, as pension and investment funds continue to look for yield.
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Despite the increased issuance of high yield bonds and the increased leverage of balance sheets, the relative stability of the global economy and global interest rates should ensure that in 2006 default rates only rise modestly from the current historically low level of around 2%.
Elsewhere, we anticipate a fall-off in the speculative demand for bonds from banks and hedge funds, as the increase in short term interest rates in the US has made cash deposits more attractive and has therefore reduced the potential outperformance of bonds.
In 2006, the combination of increased issuance, rising default rates and reduced speculative demand is likely to gradually lead to wider spreads in both investment grade and high yield markets. However, this should not be of such a magnitude that capital value changes wipe out the extra yield generated by the shorter and intermediately dated bonds that we have traditionally focused on.
As regards our portfolios, while we may not alter the investment grade and high yield weightings, in the short-term we are looking to protect them from the worst effects of spread widening in three ways: retaining focus on shorter dated maturities, increasing the quality of the credits we hold within each classification, and continuing with our core process of credit selection.
By Ian Robinson, Head of Credit at F&C Asset Management
