Corporate bonds are a sell - here's what to hold instead
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Associate Editor
David Stevenson Feb 19, 2010
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If you'd bought lower-grade UK corporate bonds at end of 2008, just 12 months later you'd be 22% better off. That's not too far short of the 28% you'd have made if you had invested in the FTSE 100 index.
You'd have been taking less risk too.
But if last year was party time for holders of company debt, this year is already looking like the hangover. It could yet get a lot worse - and that's even before you take last night's Federal Reserve move into account...
Last night's decision by the Federal Reserve to hike one of its key interest rates will mean tougher times for most asset classes. I've written more about the impact of the move here: Interest rates are rising in the US.
But even before the Fed sprang its surprise, corporate bonds were looking toppy. You may already have bought into a corporate bond fund. Though if you're not so familiar with the subject, here's a quick recap. Corporate bonds are IOUs that are issued by companies to raise money. They pay a fixed rate of income – the coupon – until maturity. This is when investors get their capital back, usually several years later.
At least, that's the theory. But if an issuer fails in the meantime, all bets are off. Depending on how bad a 'bust' it turns out to be, bondholders could well lose part or all of their money.
What's good about corporate bonds
But here's the big plus point for corporate bond investors. They rank higher in the pecking order than shareholders. In other words, they could still get paid even if the stock price plunges. Note that lower-rated corporate bonds yield more than top-notch issues, reflecting the higher risk you take when you buy them.
After corporate bonds are issued, they can be traded just like shares. Indeed, as my colleague Tim Bennett points out in this week's magazine (The party's over for corporate bonds - if you're not already a subscriber, get your first three issues free here), private investors can now do this much more easily. The London Stock Exchange has just created a market for the latter to deal alongside the big institutions.
Now if you're a contrarian thinker, you'll probably take this as a bad sign. As soon as a market gets 'opened up', it often means the best of the action has already happened. And in UK corporate bonds, such a view looks about right. In 2009 yields dropped, i.e. prices rose, sharply. That's because investors piled in, particularly at the riskier end of the market, in search of higher returns than those offered by most British shares or by UK government bonds (gilts).
The net result here was the spread – the yield difference – against gilts falling sharply. Last year it more than halved from almost 6% to just over 3%. So even though the yield on gilts climbed by 1% during 2009, lower-grade corporate bonds still managed that 22% overall return.
Problems in the gilt market will hit corporate bonds
But the game is now changing. And the gilt market is where the next set of problems is likely to crop up. Yesterday's UK state spending figures were truly awful. Our government shelled out £4.3bn more in January than it brought in, even though the average view from the experts was for a £2.6bn surplus. What's more, this was the first budget deficit to be racked up in January – when tax revenues are supposed to be good - since records began in 1993.
In other words, the government isn't just losing lots of money, it's also losing the plot. And we've recently seen from what's been happening in Greece (A bail-out will be just the start of Europe's problems) how sovereign debt problems can pan out.
Even if UK public spending gets slashed, the amounts Britain will have to borrow will still be huge. Yields on ten-year gilts have already risen to 4% from 3% in January 2009. To attract sufficient investors to take the extra risk of buying enough gilts to plug the country's funding gap, those yields will have to rise much further.
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In turn, that's likely to 'crowd out' private sector borrowers - like companies wanting to borrow in the corporate bond market. To compete with the government, they'll have to offer much higher yields - and wider spreads against gilts - than they have been doing.
So corporate bond prices - particularly at the riskier end of the quality scale - will get hit hard. But the market faces other pitfalls apart from having to mix it with big government borrowers. Over the next five years, companies across Europe have plenty of problems of their own.
Company debt will affect bond prices
Here's a very unnerving chart complied at the end of 2009 using JP Morgan data. It shows the percentage of institutional (blue bars) and bank-held (orange bars) debt issued by European companies (45% of them British) that will need to be re-financed between now and 2017. And it's clear the problems will soon be mounting up fast.
"Despite significant spread-tightening in the credit markets, there remain only limited options for rolling over this debt", says Stefano Aversa of business consultant AlixPartners. "The potential for a very serious ... crunch is knocking on the door of these companies". It all "leaves needy companies in a bind", says Lex. "The next act of the credit crunch may be bitter rather than better".
In other words, these firms will only be able to raise the cash they'll need by paying much higher yields than they are now. It's another reason for corporate bond prices to drop.
And the market is cottoning on to the dangers. The Markit iTraxx 5yr Crossover index - without getting too technical, this gauges the risk of holding lower-grade European corporate bonds - has jumped almost 30% since 8 January. While that number is a guide rather than a precise risk measure, it shows investors are already getting jumpy.
What to buy instead
So if you sell your corporate bonds, what should you buy for a high yield? In fact, there may still be an answer - European telecom stocks.
Ambrose Evans Pritchard points out in the Telegraph that five-year debt issued by Spanish phone company Telefonica (SM: TEF) yields 3.8%. At €17.4, the shares are forecast to yield 8% this year.
Meanwhile similar debt at France Telecom (FP: FTE) yields just 3.3%. This year's forecast yield on the shares is 8.4%. That's looks like a no-brainer to me.
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