Fund managers say now is the time for investors to make the most of the high-yield potential of corporate bonds. Jenny Lowe investigates.

Quantitative easing and high levels of government borrowing are leading many to conclude that it will not be long before inflation returns. Trevor Greetham, manager of Fidelity’s Multi-Asset Strategic Fund, points out that ‘The consensus view is that inflation will remain low for several years in view of the massive spare capacity in the world economy. While I have sympathy with this idea, the indicators I follow suggest that headline inflation may have troughed in August as energy prices continue to pick up from their December 2008 lows.’

Greetham believes that the UK could see a mini inflation scare early next year as the headline rate swings back into positive territory. ‘With growth strong and inflation rising, central banks will come under increasing pressure to start raising interest rates from their current emergency settings.’

Reassessing the markets
For fixed-income investors, a rise in inflation could pose a problem. Chris Heulin, head of fixed income at Collins Stewart Wealth Management, suggests that the bond market is not taking account of inflation and supply risks that threaten losses for fixed-income investors.

He says, ‘With economic indicators showing positive signs and policymakers likely to err on the side of caution by leaving monetary policy loose, we now expect a return to sustained growth with inflation rates much higher than consensus expectations. We do not believe that the bond market is correctly pricing in the risks of supply and inflation.’

Government bonds became the focus of investment inflows during the latter half of 2008, when the majority of non-bond assets, including cash, suffered substantial outflows.

Even within bond markets, outflows prevailed across many non-governmental classes, the extent of which resulted in many government bond yields hitting multi-year lows.

Bond yields fell dramatically from 2007 to the end of 2008, but long-dated bonds are already nearing a return to pre-crisis levels. For short-dated bonds, central bank interest rates have pinned yields at lower levels.

‘At some point, even short-term bank rates will rise, possibly in 2010, raising the prospect of a “bear” flattening move in the yield curve, with short-term rates rising more than long-dated yields,’ suggests Heulin.

He adds, ‘The rapid recovery in corporate bond and index-linked weightings has left us feeling uneasy as to whether these assets continue to offer value. Corporate bond spreads have narrowed rapidly, and while the majority of this narrowing is justified, we are concerned that there is little left in the spread to protect holders against any sell-off in the government bond market.’

But while Heulin has quite a bearish view on the corporate bond sector, there are others that argue the rally in corporate bond yields is set to continue.

Investec’s co-head of fixed income, John Stopford, is one such person. ‘We believe that corporate bonds have entered their sweet spot in the business cycle, whereby improving company fundamentals, declining leverage and strong investor appetite are combining with still-decent valuations to deliver what should be a protracted period of strong performance,’ he says.

This view is supported by data that suggests that the recovery from recession could be fairly dynamic as policy stimulus reinforces a sharp bounce in inventories. Stopford believes that, if this is enough to stabilise employment, it should set the stage for reasonable growth in 2010 and beyond.

He says, ‘If central banks are slow to raise interest rates, as their rhetoric suggests they could be, the growth prospects for corporate bonds in 2010 particularly is good. Plenty of spare capacity should prevent a pick-up in core inflation for a reasonable period, helping to reinforce this benign environment for financial assets.’

Bursting bubbles
In an analysis of 88 financial bubbles, Allianz Global Investors found that nearly all involved some level of inflation. Neil Dwane, CIO Europe of RCM – the equity company within Allianz Global Investors – explains, ‘Given the scale of debt emerging in the US, UK and many other economies, including Japan, inflation is the only way to make that debt tolerable to society. If it were to deflate, the importance of the debt to the economy would grow, which would be a depressing influence on underlying economic activity.’

Dwane believes that we are currently in a twilight zone: ‘Despite much of the data now getting better, many investors are looking at their returns and wondering why they are not reflecting the developments in markets.

‘The scale of government finance still remains high, and therefore one wants to end up in a portfolio of companies that can access the growth of emerging markets and the stronger parts of other economies by relying on their own finance rather than by going to a bank or investors.’

And Raj Shant, Newton’s director of European equities, agrees, suggesting that we are now nearing the point when European investors will have to switch from rerating the market’s most distressed stocks to rerating the eventual winners.

‘At the same time,’ he says, ‘the barrage of stimulus that has so far been absorbed by European economies will inevitably result in inflation suddenly bulging through the cracks somewhere. When this happens it will provide yet another reason for European investors to seek out large, high-yielding companies as, unlike cash or bonds, they provide a real hedge against inflation.  

‘In effect,’ he adds, ‘so long as Europe’s governments continue to pump stimulus into their economies, they will be helping some of the strongest and best-managed companies, and it is these very same companies that hold the key to Europe’s mounting income crisis.’

Soldiering on
Global equities have marched ahead smartly since the spring, but valuations are still low compared with a year ago. Equities are highly attractive when compared to other asset classes such as cash and bonds, where yields are low and likely to remain persistently so.

‘Progress since April arose as investors readjusted from a highly risk-averse attitude to a more normal stance,’ says Richard Turnill, head of global equities at BlackRock. ‘We believe the next leg of the bull market will be driven by earnings.’

The earnings cycle has already bottomed out but expectations of earnings growth remain stubbornly pessimistic, with many predicting positive earnings surprises right across the market.

Turnill also suggests that, in developed markets, cyclical companies such as financials still offer value. He adds, ‘We are balancing these holdings with exposure to deep-value companies with strong earnings streams, good cash flow and attractive dividend yields. Yields of 6 to 7 per cent a year are available from telecoms, tobacco, healthcare and media companies, and we are confident that this yield will be maintained. Such shares are eye-catching compared with the 1 to 3 per cent yield to be expected from bonds and cash.

‘In developing markets, companies will benefit from a continuously high level of liquidity – the amount of cash available for investment. We expect interest rates to remain low globally until 2010/11, maintaining a high level of liquidity in economies, and reducing the attractions of cash and bonds. In these markets the consumer-facing companies, property and even investment banks are attractive.’

And as markets in two of the world’s leading economies continue to rally, the question being asked by many investors is whether we are, in fact, in the beginning stages of a global recovery.

Charles Schwab’s Kully Samra explains, ‘Over the past couple of weeks we have started to see positive signs from both sides of the Atlantic. This is encouraging news for investors, but what is particularly interesting is that active UK retail investors believe the US will actually recover ahead of the UK.’

A survey of more than 1,400 UK-based retail investors, carried out by Charles Schwab, reveals that 44 per cent believe that the US economy and markets will recover sooner than the UK. However, only 17 per cent of respondents actually invest in US stocks.

Samra explains, ‘It seems as if UK investors are missing out, as the US can provide a whole wealth of investment opportunities. For example, one can choose to invest directly in US companies, which enables an investor to tap into many different sectors.  Those who invested in US stocks actually believed that the information technology and energy sectors are attractive, which is reinforced by our sector recommendations.  

‘We continue to believe that global reflationary policies, combined with improving economic prospects, will benefit the more cyclical technology, industrials and materials sectors. In contrast, we believe the defensive-oriented consumer staples, telecommunication and utilities sectors will underperform.’