UK corporate bonds have recovered considerable ground since the Covid-19 crisis, but the market continues to present an unusually appealing array of company-level opportunities.
Over the last two decades UK investment grade corporate bonds outperformed UK shares, and by a fair margin. This was largely due to the collapse in interest rates (bond prices move inversely of interest rates). With rates at or near zero along the UK government bond curve, this is unlikely to be repeated in the future.
On the other hand, interest rates are also unlikely to rise in the foreseeable future. With increased debt burdens and ample slack in the labour market, higher interest rates will be detrimental to the economy and would jeopardise the finances of many individuals and corporates.
The expected stability in interest rates imply that UK corporate bonds should hold on to their gains, but adding to them will not be so easy in future. “Buying the market” is unlikely to get the same results over the next 20 years as it did previously.
Added to this, the market has swiftly rebounded from the severe shock of the Covid-19 crisis and valuations are no longer attractive by historical standards. Outright yields are low and credit spreads to government bonds are roughly in line with the long term median level.
Active approach required
The UK corporate bond yield reached 3.5% at the height of the crisis, equating to a spread of over 280 basis points (bps) over government bonds with the same tenor. As at mid-September, the levels were 1.7% and 150 – a strong retracement. The good news, however, is that the dispersion within the market is substantial. The range of yields on offer across the market is wide, something which is not readily apparent when you look at the aggregate index levels.
In these circumstances it makes little sense to “buy the market” indiscriminately, and therefore we focus on the higher yielding bonds, weeding out the losers and backing the winners. The key to success is rigorous and long-term focused credit research to identify the survivors whilst ignoring short term market gyrations.
Covid-19 crisis: Three distinct phases of opportunity
Phase 1 (peak crisis, focus on “Covid-resilient” opportunities): In the height of the crisis in March the focus was buying corporate bonds in Covid-resilient sectors such as pharmaceuticals, telecoms-media-technology (TMT) and defensive consumer businesses. There were once in a lifetime opportunities in these sectors as even companies that were likely to benefit from the crisis sold off aggressively. For instance the price of bonds of Perrigo, the largest cough, cold and pain medication maker in the US, fell to low levels. To us, however, it was apparent that Perrigo, would perform well as a beneficiary of the pandemic and, alas, it recorded double digit organic sales growth so far this year. Bonds in these sectors were early to recover.
Phase 2 (opportunities in “best-in-class”, high quality cyclicals at depressed valuations): As the very worst of the crisis started to abate, the next step was to pick the winners in cyclical sectors and in sectors hit by coronavirus. This included best in class, sector-leading companies that have enjoyed both government and shareholder support. One notable opportunity was the bonds of the airline Ryanair, maturing in 2021 with over 20% yield. The company entered the crisis with an unassailable position as the lowest cost European flight provider with very little net financial debt and a broadly unencumbered plane fleet. The opportunity to invest in an industry leader at extreme valuations is about as good as it gets.
Now we are in Phase 3 (less exciting, but plenty of “hidden” opportunities): The overall market valuation has become unexciting, but there is considerable opportunity for security selection. Key, amid such a uniquely uncertain situation, is identifying companies with tenable balance sheets and business models which will remain unimpaired on the other side of covid.
We apply rigorous credit research to invest in credit with higher yields than the benchmark, plenty of these yield in excess of 4%. A particular area of focus is the lowest rated segment of investment grade (BBB-) and credits which have been affected by covid. Our north star is the margin of safety, which means only investing in bonds where the yield greatly overestimates the company’s default risk.
A golden era for bond selection?
Even as the market valuation has become less exciting in aggregate, the dispersion of the market looks interesting. A wider range of prices implies a degree of mispricing and therefore scope to generate good returns, through an active approach. Our analysis of companies has identified numerous bonds which are cheap in relation to their fundamentals.
The charts below illustrate the ratio of yields and spreads on BBB to A-rated UK credit. A higher ratio indicates a wider gap and a greater array of investment opportunities.