The bond markets are undergoing a transformation with several fundamental changes happening in the asset class. One of these shifts is that pension funds have become the main driving force behind a resurgence in the UK corporate bond market.
Moreover, companies in mainland Europe’s largest economies, in the form of Paris-based luxury goods company Kering and German real estate group Vonovia, are issuing sterling bonds for the first time.
This boost is evident in numbers revealed by the Financial Times, which show that the share of European corporate bond sales denominated in sterling has risen to 8.4% from 6.8% a year ago.
In addition, the latest version of the Pension Protection Fund’s (PPF) Purple Book reveals that there has been a decent shift into corporate bonds by pension schemes in the past year, where allocations rose to 36.5% from 30.2%, while index-linked bonds fell to 44.1% from 47.8%.
But Damien Hill, senior credit portfolio manager at Insight Investment, makes an important observation about the state of the market. “Actually, the UK corporate bond market is reasonably diversified by issuer: only about 54% of the index is UK-based corporates,” he says. “That is compared to Europe, where it is more like 69%, and the US, where it is above 70%. In a way, the sterling investment-grade market is more diversified.”
So much of this on-going development within the UK bond market is, in part, baked into the asset class itself, but it is also a trend that has been in place for a while. “A lot of the issuance we have seen post-Brexit has been for those who need sterling funding with long maturities – UK banks, housing associations and utilities,” Hill says. “They need funding for the long term, and that gives a skew to the market.”
That said, he adds that there has been a new shift into bonds, with some different issuers at play. “Some of the issuance we have seen over the last six months to a year has been out of auto [car companies] and more cyclical industries, that tend to be sub10 year,” he says.
Long-term gains
In addition, the bond boost comes after the sterling debt market has probably been somewhat under supplied, particularly for longer maturity bonds, Hill says. In addition, for overseas-based investors there are unique reasons to invest in British corporate debt.
“When the market gets funding from Germany or France, they are likely to diversify funding in the UK particularly because you can pick the maturity more forensically in the UK,” Hill says. “In Europe, you tend to have a lot of issuance that is sub-10 years in maturity. That tends to be the focus: a shorter duration market.”
So what the UK markets give pension schemes, which have longer-term liabilities, are much longer maturities through 15, 20 and 30-year bonds. Indeed, higher credit worthy companies from the US and Europe have issued in the UK for the past decade partly for this reason.
The move into bonds also comes from the obvious attraction of higher yields, thanks in part to the shifting macro-economic environment.
According to Vanguard’s forecasts, the expectation for UK bonds is to return around 4.9% on an annualised basis over the next decade, compared with its previous 10-year annualised forecast of 1.3%, which was before the much dis- cussed rate-hiking cycle began. “The long-term outlook for bonds is better than it has been for many years,” says Lukas Brandl-Cheng, an investment strategy analyst at Vanguard Europe.
Put another way, Hill says: “Yields now on UK investment grade are in excess of the yield you get on the FTSE100, which is traditionally a high dividend paying index.”
The attractions do not stop there. “A bond gives you contractual income and sits higher up in the capital structure if an issuer gets into difficulty,” Hill says. “That is attractive for institutional investors.
“Also you are getting pickups in bonds that we haven’t seen since the global financial crisis more than 15 years ago.” Although on the issue of defaults, it is worth pausing to consider the latest report from Moody’s, which showed that the corporate default rate last year hit its highest level since the start of the pandemic at 4.8%.
Structural tailwinds
Then there are other economic factors that support the investment case for bonds. “We subscribe to the view that in the medium term, inflation is going to have structural tailwinds,” Hill says. “You think about de-globalisation trends, extreme geopolitics and ultimately climate change. These are all medium-term tailwinds. So we expect yields on corporate bonds to be somewhat higher than they have been, particularly during the quantitative easing era.”
Moreover, this means corporate bonds are going to settle into a nice income-generating asset class. “It can be a larger and more attractive part of investor portfolios in the medium to longer term,” Hill says.
Bonds are more of an income story for Blackrock but leading to a different version of the asset class. “Our inflation view keeps us maximum overweight inflation-linked bonds. And within developed market government bonds, we still prefer short and medium-term maturities,” says Wei Li, global chief investment strategist at the Blackrock Investment Institute.
Looking at the outlook, Hal Cook, senior investment analyst at Hargreaves Lansdown, draws out some interesting perspectives. “Now we are out of the interest-rate rising cycle, interest rates could potentially go up or down from here. If there is a market shock, it is quite possible that interest rates could be cut or that there could be a flight to the safety of gilts. In that scenario, shares would likely lose value and bonds would increase in value.”
Textbook theory
This could lead back to more conventional investing. “The standard textbook theory that investing in shares and bonds gives you a smoother investment return over time might be back,” Cook says.
That said, if interest rates fall because inflation is considered under control, then that will likely be good for shares and bonds. “We saw this in the final two months of 2023 where markets thought that further interest rate rises were completely off the table and that cuts would be coming soon,” Cook adds.
While looking at the macro outlook, Nick Burns, a portfolio manager at Payden & Rygel, says investors should keep the micro picture in mind when thinking about bonds. “One of the themes everybody talks about is the macro-economic environment, and that is obviously important, but the micro-economic perspective is important too. We have seen persistently positive results in terms of issuers continuing to maintain balanced balance sheets and balanced credit metrics, with overall fundamentals that suggest that they are prepared to manage through a recession.”
But, he says, this is unlikely to be tested, as a recession is doubtful. “I don’t think a recession is anybody’s base case at this point but you still have a lot of comfort with the margin of safety that you are getting from the issuers in our universe.”
The essence of this is that bonds are a much more attractive asset class than they have been. But is there a specific focus investors should keep in mind?
“Investment-grade credit is probably the sweet spot relative to other areas, relative to high yield or government bonds at this point in time,” Hill says. The announcements made in March’s spring Budget could also boost the bond market – a statement that is probably not made often. “The British ISA [designed to encourage investment into UK companies] could help the UK corporate bond market as well, giving it a little more of a kick,” Hill says.
Negative correlation
In an interesting twist on the whole bonds debate, research from Managing Partners Group has shown that institutional investors expect the correlation between bonds and equities to turn increasingly negative during the next 12 months.
This puts bonds back in play in a major way. A point not lost on Hill. “From an investment perspective you definitely want a higher allocation to bonds,” he says.
In addition, as defined benefit pension schemes get more mature, there has been much activity in sponsoring companies transferring them off their balance sheet to an insurer. Insurers prefer portfolios to be exposed to investment-grade assets, so a great deal of final salary schemes have found their way into the corporate bond market, as evidenced by the Purple Book’s data.
This trend is likely to be here to stay for another decade. But then defined contribution schemes will take over. And as they get more mature, and with an aging UK population, there is going to be a strong demand for bonds from these schemes. A point highlighted by PPF chief actuary Shalin Bhagwan.
“Just as the PPF has entered a maturing phase, the wider defined benefit universe looks to be similarly moving into a new phase with many schemes accelerating towards buyout funding levels,” he says. “This will likely further sharpen the focus on endgames and the options available to schemes.”
Shifting market
The Managing Partners’ survey also reveals the extent to which the plates within the bond market continue to shift. US investment-grade corporate bonds and gilts are the fixed income asset classes most appealing in this sector. Bonds issued by the Swiss government and the European Union as well as UK investment-grade corporate debt are also highly rated.
On this level, Scott DiMaggio, head of fixed income at Alliance Bernstein, says it is not just UK debt that looks attractive, but those issued in other global domiciles are also appealing. In the euro area, he points to AAA-rated 10-year German bunds as an example given that after years of negative yields they now offer 2.44%.
In the US, where inflation – while declining to 3.1% – is still well above the Federal Reserve’s 2% target, he expects rates to remain elevated into the second half of 2024. “Given current trends in economic data, we think the Fed has completed its rate-hiking cycle and will remain on pause until inflation is closer to 2%, when it can begin to ease in the face of cooling US growth,” he says.
Despite the rally in treasuries, yields remain “compelling”, he adds, with US 10-year treasuries now yielding 3.9%. “For bond investors, these conditions are nearly ideal,” DiMaggio says. “After all, most of a bond’s return over time comes from its yield. And falling yields – which we expect in the latter half of 2024 – boost bond prices. Investors should consider extending duration in this environment to gain exposure to rates,” he adds.
It does mean that not only are bonds back, but investors should be giving their portfolios a bond boost.
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