Sterling corporate bonds offer attractive potential returns, August 2023

Fixed income may not exactly be back in fashion, but a pretty big shift is happening, and UK corporate bonds are offering up very decent potential to entice investors to buy in.

Data from the Investment Association always has a long lag, but its latest figures showed fixed income led inflows with £632m in May, and almost double that at £1.1bn in April. This is an extreme turnaround from last year, when the asset class saw £662m redeemed.

Inflation reprices bonds

High inflation globally has completely repriced global fixed income, including UK corporate bonds, in the last two years. With rapid hikes in interest rates in the US and UK, this led to a lot of pain for fixed income investors in 2022. Further hikes in 2023 have kept upwards pressure on yields.

But, says TwentyFour Corporate Bond fund manager Chris Bowie, “a much higher starting level of yield in 2023 has meant that total returns from sterling credit have remained positive, and in our view yields continue to remain very attractive”. 

UK corporate bond returns are certainly looking impressive. For a high quality investment grade portfolio, a return of 7% a year is Bowie’s central case for the next two years or so.

This is “a relatively conservative view”, he says, as it is simply the yield on offer, without factoring in the chance of base rates starting to fall in the second half of 2024 as is predicted.

If base rates do indeed end up being cut towards the end of 2024, “then that would be very good for UK corporate bonds, and returns could end up being much higher than 7% a year,” he says.

Beyond that two-year horizon, a return of 5.5% to 6% is a more likely sustainable and achievable annual return for high quality investment grade credit.

Sterling opportunities

Baillie Gifford’s Strategic Bond fund is a best ideas global corporate bond strategy – and Lesley Dunn, co-manager and head of credit at the firm, specifically likes the sterling corporate bond market. 

She says: “Its composition is global, circa 50% of participants are non-UK domiciled issuers, so it offers a diverse opportunity set.

“It is also small, in relative terms, and generally overlooked by international investors, resulting in a liquidity premium that means it persistently offers value relative to euro and dollar markets.”

Investors have to be discerning, she cautions, as inflation remains uncomfortably sticky in the UK, meaning the backdrop for many UK-domiciled issuers is challenging.

For example, Lesley likes subordinated BBB-rated bonds (those on the lowest rung of the investment grade ratings spectrum) issued by UK insurers, which offer extremely attractive yields in a global context.

“We like bulk annuity providers such as Pension Insurance Corporation, whose business models are supported by a strong structural tailwind. Demand for their products has increased as gilt yields have risen,” she says.

The fund manager also recently participated in a new issue from Admiral Group where, in her view, the valuation on offer and its enduring position as a market leader in UK car insurance offset the risks associated with its exposure to the British consumer.

In a recent note, the team behind M&G’s Corporate Bond and Strategic Corporate Bond funds said the current macro backdrop and the valuation reset in corporate credit “presents active investors with a wealth of opportunity to lock in yields at very attractive levels”. 

From a fundamental perspective, the team thinks investment grade companies are still in good shape and investors are being well-compensated in distinct sectors like banking, insurance and utilities for any reasonable expectation of default.

Furthermore, the team says “by providing exposure to both interest rates and credit, we believe investment grade corporate bonds in particular offer natural diversification qualities and can provide resilience during uncertain market conditions”.

The key threats to the return potential in the sterling credit market are further rises in either interest rates or default rates.

However, as Shalin Shah and Matthew Franklin, co-managers of the Royal London Corporate Bond fund, point out, the market is now less interest rate sensitive than at the end of 2021 due to a higher yield environment. 

“We would expect that the higher income on offer would help to offset the negative impact of further yield rises,” they say.

The managers expect company default rates to rise as the impact of higher rates feeds through onto balance sheets. But they also believe “you remain overcompensated for historical default rates when invested in a diversified portfolio, with good downside protection”.

While corporate bonds have a higher risk of default and are often less liquid than (risk-free) sovereign bonds of leading developed markets with the same maturity, they compensate for this by offering an impressive excess return in the long-term.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.

Published on 01/08/2023