There’s plenty of evidence to suggest investors should be avoiding corporate bonds. Not only are prices are at record highs (and yields at, or near, record lows) but global economic growth is slowing and ultra-low interest rates look unlikely to rise any time soon.
And yet it's difficult for many institutional investors – most notably insurance firms – to avoid some exposure to credit because of their mandated fixed income allocations.
So what should they do?
For Urban Angehrn, group chief investment officer of Swiss insurer Zurich, the challenge is to “pick your poison” in a choice between buying pricey corporate debt or sitting on cash yielding zero or worse.
You must “choose the lesser evil,” he said, while speaking at the FT Investment Summit in London last month.
Zurich, which has $195 billion under management, needs liquid capital to be able to pay its liabilities but both cash and corporate bonds are providing ultra-low yields these days.
Yet credit spreads – the difference between the yields on government and corporate bonds – are historically low in the US and Europe.
“It’s fair to say that … credit is really, really expensive,” he said.
HOLDING ONE'S NOSE
Hence, Zurich is having to “pinch its nose” when buying corporate debt these days, especially given the gloomy backdrop, Angehrn said.
“We live in a world of unprecedented levels of debt, corporates have significantly geared their balance sheets, and credit quality of corporate bonds has on average deteriorated.”
Following a decade of unprecedented monetary easing, credit markets are showing many imbalances and vulnerabilities that could persist for a long time even without a downturn, he said. But when the cycle turns, “these vulnerabilities [will] present a lot of risk”.
And certainly bond investors in general are being more selective than they were two or three years ago, said Alex Griffiths, head of Emea corporate ratings at credit rating agency Fitch.
While they have to stay invested, nowadays they are exercising a lot more discretion, he added, speaking on the same panel as Angehrn. “They’re not jumping into anything just because there’s some yield on offer,” Griffiths said.
Certainly, the chief executive of Alecta, a $90 billion Swedish occupational pension fund, is wary of corporate credit.
“Valuations of corporate debt are extremely rich today,” Magnus Billing said during the same panel discussion. “So we’re very reluctant to enter into corporate bonds today. But you have to allocate, irrespective.”
Nonetheless, Alecta would need to see a pickup in economic growth and a rise in interest rates before investing more into corporate bonds, Billing noted.
He is also concerned about reduced credit market liquidity these days, given that banks have a much smaller market-making capacity for bonds than was the case before the 2008 crisis, due to regulatory changes.
“That is going to be a major issue when we get to the point when the market turns [and interest rates rise],” Billing said.
Zurich has responded to its corporate bond dilemma by remaining invested in the asset class but being a little more conservative in its allocation in the short-to-medium term. It has sought to increase the quality of its fixed income portfolio across all assets, from mortgage lending to infrastructure debt to high-yield bonds, Angehrn said.
Ultimately, the overall risk remains the same, he added. “If I were to massively de-risk the credit portfolio – which we could do – something else would have to become more risky. We’d hold more equities, or something else instead.”
A major focus for Zurich now is keeping a close watch on the level of beta, or general market exposure, in its credit portfolio. To that end, the insurer introduced what it calls ‘beta control’ following the 2008 financial crisis.
“We did not have beta control in 2007 and a lot of the outperformance from 2004, 2005, 2006, 2007 that we got from bond managers turned out to be [from] long credit beta,” Angehrn said. “So in 2008 we had a huge amount of underperformance.”
As a result, the insurer completely restructured its approach to monitoring total credit risk after the crisis.
Angehrn also stressed the importance of retaining some active management of corporate bonds.
“While we haven’t had a whole load of defaults to prove it, if an asset manager avoids one or two defaults for you, that is a massive source of alpha," he said. "And as conditions get a bit more dicey, that is a significant reason to have active management, certainly in the lower quality end of the credit spectrum.
"I think outsized excess returns [from credit] are possible," Angehrn added, "particularly in a downturn."
Investors will hope that will be a potential silver lining to the cloud many see looming over markets.