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When will the corporate bond bull market burst?

Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.


 

I have a three different investing strategies, all with fundamentals at that their core. One of my investing strategies focuses on macro trends, i.e. looking at what I believe to be under valued asset classes, sectors and currencies on fundamentals. I then pick appropriate ETFs and Investment trusts to get exposure to these areas.

In today’s post I look at the sterling corporate bond asset class and specifically at the iShares Core Sterling Corporate Bond fund (SLXX). Corporate bonds have been on a bull run since 2009, well actually you might argue the run has been in play since 1980. My favourite in the Sterling Corporate Bond sector, iShares Core £ Corp Bond (SLXX) had seen 45% capital gain alone from mid-2009 to the most recent peak in the market at August 2016. When you add distributions over the same period you can add a further 30% on top. This is a whopping 85% return in 7 years, these are equity like returns.

Firstly, how can I gain exposure to Sterling Corporate Bond?

As above my favourite in the sector is SLXX, the fund is an Exchange Traded Fund (ETF) which tracks the Markit iBoxx GBP Liquid Corporates Large Cap Index. This is an index of large cap, liquid, investment grade bond issues. At 8,000 issues it is also very well diversified. It is therefore a great way of getting exposure the to corporate bond asset class at large. It is also worth mentioning that with an average maturity of 14 years it gives a longer dated exposure to bonds, this becomes relevant later.

As mentioned above the fund has done very well and performed well ahead of the sector and a similar mutual fund offering from BlackRock (see figure 1). The total expense ratio (TER) is 0.2%, higher than BlackRock corporate bond tracker which Hargreaves Lansdown can offer at 0.12% TER. However many fund brokers such as HL also include a management fee on mutual funds, for HL this is 0.45%, so the true cost of this could be upto 0.57%. This of course depends on your circumstances and also bear in mind dealing fees with ETF. I’ll do a separate piece at some point discussing the pros and cons of different ‘wrappers’ for your investment.

bond-chart
Figure 1 – SLXX vs Sector and Peer. Source – Financial Express

Anyway, not much more to say on SLXX, it’s an ETF. You can access this asset class in many ways, the important factor is the macro picture though…

So can the corporate bond bull market continue?

Let’s start with the basics. There is a an inverse relationship between Corporate bond prices and the yield. The demand and hence the price of corporate bonds are solely a function of risk (represented by yield), and this can be subdivided into two factors:

  1. Interest Rate Risk – Relative yield of corporate bonds versus other asset classes, most notably cash.
  2. Credit Risk – Real or perceived Counterparty risk .

Is the yield on corporate debt now too low? Are we consequently due a fall in bond prices?

The yields on sterling corporate debt hit a record low earlier this year. A major factor behind this is the ongoing quantitative easing, where the central bank buys investment grade corporate bonds, among other assets. The logic here is that by buying bonds this increases the price, reduces the yield and hence the cost of corporate borrowing. This should theoretically stimulate the economy. Some argue though this action from the central bank distorts the yield and doesn’t fairly represent the risk of holding corporate bonds. Taking our fund from above, the current average Yield to Maturity (YTM) of SLXX is 2.77%, this compares to an Weighted average coupon (WAC) rate of 5.09%. This means the average bond in the SLXX fund is yielding around 1.4% less than the underlying coupon rate of the bond. This means the bonds held by SLXX are trading at a premium to issue price, a 26% premium to be precise, as at 16th December 2016.

This premium sounds extreme but a yield of 2.77%, despite being well below the coupon on the bonds is still significantly more than you can hope to achieve by parking your money in cash. But what about a Sub Investment Grade Emerging Market Bond Fund? The iShares WING fund has a current YTN here of 4.86%. But this sounds high a risk fund right, but a yield of less than 5%? Would you lend your money at this rate? Do you feel more comfortable with 7.5%, or perhaps even 10%? A yield requirement of 7.5% or 10% would represents a 16% or 29% underlying decrease to the price of the bonds. I am very concerned about counterparty risk on ‘high’ yield corporate bonds, default rates of 5-6% would not be uncommon in any economic downturn, this would start to seriously affect the returns of bond investors and could trigger a flight to safety. Investment grade bonds are unlikely to have the same counterparty risks but may be dragged down in association.

Now let’s look at the second risk, interest rate risk. A major factor causing people to turn off from investment grade bonds is potential yield from elsewhere such as increasing interest rates on cash…

Are UK interest rates likely to rise?

As mentioned above the price of bonds are very sensitive to interest rate increases. A hypothetical scenario but if the interest rate for cash increased to 3% then given SLXX and similar bond funds only offer a YTM of 2.7% then a rational investor would sell SLXX as cash is zero risk and has more liquidity than bonds.

We are a long way from 3% base rate though granted. We are in an era of ultra low interest rates, it’s been that way since the 2008 financial crisis and the general trend has been down since the late 70s (see figure 2). Whilst 3% base rate is unrealistic in the near term the current interest rate is 0.25%, so there is also very little potential for further decreases and therefore upside to bond prices from this factor.

uk-base-rates-79-11
Figure 2

What is the likely trajectory for base rates from here?

Interest rates are a monetary policy tool to control an overheating economy, one where inflation is running high. The collapse in Sterling post Brexit is starting to impact inflation given we import a lot of raw materials and a lot of the food we eat.  Could this force the MPC to increase rates? The risk is currently considered low, current predictions are that interest rates won’t make it to 0.5% until 2021. But since when did the experts get it right?

If interest rates do rise then longer dated bonds are likely to be much more sensitive, this is for the simple reason of longer exposure to the narrower spread between base and current yield. A shorted dated ETF such as iShares £ Corp Bond 0-5yr UCITS ETF (IS15) may be safer, but for obvious reasons the current yield is much lower.

SUMMARY

Sell

I am not saying the next bubble to burst will be corporate bonds, I just see very little upside from here and on balance more potential downside so this comes down to risk/reward ratio for me. Interest rates increases are unlikely in the near term, but then so was BREXIT and Trump for president.

Disclaimer – I have no positions in any of the stocks mentioned. To my knowledge no close family, friends nor associates have any further position. 

This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.

Categories

Macro, SLXX

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