Head of Credit and Core
Corporate bonds play a pivotal role in diversifying, and potentially increasing, the overall long term value of an investment portfolio. In this article, we look at the role of corporate bonds in a low-growth and low interest rate environment, and provide the short to medium-term outlook for this asset class.
In an economic environment of subdued growth and low inflation, corporate bonds can offer the security of a steady income stream and capital preservation. Often corporate bonds provide higher returns than cash, government bonds or bank term deposits.
With Australia’s official cash rate position of 2% expected to fall by a quarter of a percentage point in the coming months, corporate bonds look to be worth more in the short term. The theory goes that when interest rates inevitably rise from their current depressed levels, the value of bonds will decrease, although income can offset some of this decline.
Corporate bonds rank higher than shares in the capital structure, so high quality bonds issued in Australia from companies in stable industries are generally safer than equities from the same company. These investments are most effective as a defensive investment strategy when they are managed to minimise the risks associated with interest rate movements.
Three ways corporate bonds can add value to your portfolio
1. Regular income
Corporate bonds provide a regular income, as the investor receives regular interest payments throughout the investment period, as well as the issue price on the maturity date.
2. Protection from economic weakness
Bonds are considered to be defensive ‘risk-off’ investments that tend to perform well during periods of weak economic growth, primarily via duration and capital structure but can vary due to the credit quality of the underlying issuer.
In a volatile economic environment, corporate bonds can be a good alternative to shares. The defensive characteristics of bonds can provide an offset to sharemarket weakness. Not all credit or corporate bond funds are the same and consequently, it is important to seek funds that are positioned defensively to minimise the risk of default or loss of principal.
Corporate bond market outlook
Here we shed some light on what to expect from this asset class in the current environment by providing the near and medium-term outlook for this asset class, as well as credit ratings and our sector and stock selection.
Near-term corporate bond outlook
- We expect investors to remain increasingly cautious in the near term due to rising risks from China, emerging markets and other related commodity markets, and low global bond yields as central banks tackle diverging policy.
- We are anticipating market volatility through the US tightening cycle. Indeed, we have started to see signs of this playing out indirectly through linkages into emerging market stress. The risks of a more dislocated outcome are increasing, and we are positioning our credit funds defensively, accordingly.
- Recent announcements from central banks such as the Bank of Japan, and the large stimulus program from the European Central Bank (which includes quantitative easing via the purchase of corporate bonds), has removed some of the tail risks. They will also provide support for corporate credit in related regions and indirectly to other regions by spill over effects.
Medium-term corporate bond outlook
- Increased regulation will ensure bank lending activity remains at low levels and financial market liquidity will be more challenged.
- The global economy continues to modestly improve driven by the US, but emerging market weakness is increasingly weighing on global growth.
- Signs of corporate re-leveraging are becoming increasingly prevalent however, cash flow metrics at this stage are not yet broadly deteriorating. Importantly, there have been some signs of bondholder-friendly activity, including capital raisings and other initiatives, in the most pressured industries.
Credit ratings and credit maturity strategy
- We remain constructive but cautious (in the near term due to global policy conditions, timing and transitioning) on the ‘top-down’ picture for credit. However, we need to see global macroeconomic data continue to improve, commodity price stabilisation, bondholder friendly activity to continue and valuations to hold in order to provide an meaningful increase in our exposure.
- We maintain a preference for shorter dated, low investment-grade (A/BBB) rated assets, which play to the key themes that will benefit in this stage of the cycle.
Sector and stock selection
- Our sector preferences are for strong market leading corporates, as well as ‘national champion’ financials that are still in deleveraging mode. We still like segments of utilities and infrastructure related industries.
- We remain cautious on commodity related sectors, until we see further stabilisation in China and emerging markets.
- Security selection will become increasingly more important as we move through this next phase of the credit cycle.
- Investors may wish to maintain a cautious approach when determining strategic allocations across sectors and issuers, particularly towards those issuers showing some signs of fundamental underperformance, ‘shareholder-friendly’ policies or those that have aggressive growth aspirations.
While the overall outlook for bonds is for low returns, high-quality corporate bonds can continue to provide regular income and diversification within an investment portfolio. Effective management is vital to ensure the defensive benefits of this asset class are reached, and to ensure the right opportunities are taken to invest in the companies and sectors that offer the most attractive yields.
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.