By Paul Sweeting
Government bond yields have been falling for a number of years. Apart from the spike in spreads around the time of the global financial crisis, corporate bond yields have followed their sovereign counterparts downwards. We know that at least some of the falls in government yields have been as a result of the Bank of England’s (BoE) policy of quantitative easing (QE). However, at least part of the rationale for this policy was that falling government yields would drive investors into corporate bonds, thus driving down the cost of borrowing for companies.
The increase in pension schemes’ exposure to corporate bonds over the last few years suggests that this policy has worked, although allocations to credit were rising long before QE. But has QE driven corporate bond yields too low?
When JP Morgan Asset Management looked at the impact of QE on UK pension schemes – in particular on the UK government bond markets – it was clear that the impact had been significant, if temporary. However, using the same model to analyse the impact on corporate bond yields revealed an apparent difference of 250 basis points between where yields were and where we thought they ought to be.
But it is rash to blame QE for all of this difference. Rather than yields falling below their predicted levels only when the BoE was buying gilts, they appear to have dropped in steps since the start of the bank’s programme of QE. This suggests that there has been a rerating of the yield that investors are willing to receive in return for the risks they face, perhaps driven by the broader thirst for yield.
However, just because yields have fallen this does not mean they are too low. Providing companies are still well-placed to make their coupon payments, sterling credit could still offer good value. One way to determine this is to consider the income cover of companies that have issued sterling corporate bonds. These look relatively healthy, particularly in comparison to historical numbers. This suggests that while yields are low, the spreads are not unreasonably low given the corporate earnings. This view is backed up by falls in leverage.
However, despite being reasonably priced, sterling credit does not offer unambiguously good value. As such, it is worth looking elsewhere for better opportunities. The best way to assess these alternatives is to look at the option-adjusted spread on other fixed income investments that are as directly comparable as possible with sterling credit. For example, it is possible to look at spreads on Baa-rated industrials. Using this metric, US credit offers more attractive spreads beyond the 10-year term; beyond 20 years, euro credit is even more attractive. And at all terms, hard currency corporate EMD – of the same sector and rating – is more appealing. All of these can be hedged back to sterling. So, while bonds are not expensive, nor are they cheap. But for investors willing to shop around, opportunities to secure income more cheaply do exist.
Paul Sweeting is European head of the Strategy Group at JP Morgan Asset Management
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