Corporate bonds: top stock selection tips and investment outlook
Corporate bonds can play a pivotal role in diversifying, and potentially increasing the overall long term value of an SMSF investment portfolio.
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. In this article, we look at the role of corporate bonds in a low-growth and low interest rate environment, and shed some light on what to expect from this asset class in the near and medium-term.
3 ways that corporate bonds can add value to an SMSF portfolio
In an economic environment of subdued growth and low inflation, corporate bonds can offer SMSF investors the security of a steady income stream and capital preservation. Often corporate bonds provide higher returns than cash, government bonds or bank term deposits.
Corporate bonds also 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 that corporate bonds can add value to an SMSF 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.
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.
Outlook for corporate bonds
Short term: 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.
Medium-term: 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. However, signs of corporate re-leveraging are becoming increasingly prevalent, cash flow metrics at this stage are not yet broadly deteriorating.
What does this mean for investment strategy?
We remain constructive but cautious (in the near term due to timing and transitioning) on the ‘top-down’ picture for credit. However, increased volatility and recent credit spread widening will ultimately provide an opportunity to tactically add back some risk, particularly as global policy conditions primarily still remain supportive. Overall, we maintain a preference for low investment-grade (A/BBB) rated assets; we’ve been progressively reducing the tenor of investment deals.
Top tips on sector and stock selection
Our sector preferences are for strong corporates, utilities and infrastructure, as well as ‘national champion’ financials. Security selection will become increasingly more important as we move through this next phase of the credit cycle.
SMSF 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.
About the author
David Carruthers is the Head of Credit and Core at AMP Capital where he leads the Global Fixed Income team’s credit and core bond fund capabilities and is responsible for macro credit strategy.