It is a scandal that is increasingly likely and, if it occurs, it will likely envelope parts of the legal and banking sectors just as much as the investment industry as professional classes, across the developed world, have been asleep to the implications of a decade of increasing financial irresponsibility.
Worse the only way the scandal may be avoided, and in the short-term only, is if global authorities turn-up the irresponsible policies to eleven. Even this is only likely to delay the mathematically inevitable denouement, while concurrently increasing inequality, just as the global consciousness change is gathering momentum.
Why might this happen? Simply because of an epic misunderstanding about the apparent/alleged safe-haven that is the Corporate Bond, a polite term for yet more debt.
We have covered this topic before, covering the basic misunderstanding of the risks and nature of Corporate Bonds (for instance HERE) and the utterly flawed Modern Portfolio Theory behind the often large portfolio allocations in the asset class (HERE – If you have any Model Portfolio Exposure you need to read this one), however reviewing a real portfolios brought to us by a single individual was, put simply, quite chilling. Worse the portfolio was a combination of an IFA run portfolio managed on a model provided by a large insurance company, and in-part a portfolio managed on the advice of a very large on-line IFA and platform provider. In short it was directed by people who should know better.
Below is an edited version of the report we produced for the individual concerned, and as such is useful for any non-fixed interest expert, which I would argue includes almost all IFA’s and most Investment Managers. All personal details, specific fund references and anything that could be deemed as personal advice is removed, but the essence of the report, on the actual investments in real “lower-risk” portfolios is there.
(We will cover some of the more technical market issues in a following post)
Corporate Bond Fund Review
Corporate Bond funds have become an investor mainstay, utilised to reduce risk and diversify portfolio returns away from the stock market, while interest rates have been pushed close to zero in many parts of the world (and in Europe remain in negative territory) the ability of bonds to pay an income has increased their attraction.
Thus, Corporate Bond funds have been consistently the best-selling investment funds, creating a large pool of investor capital hungry to fund new company debt. However, while there are many well manged funds in the sector there are serious questions, the answers to which rather undermine most investors and investment advisors assumptions.
Questions that need to be addressed:
- Do Corporate Bond funds provide the genuine portfolio diversification and risk reduction investors assume?
- Does the growth of the Corporate Bond sector portend large economic risk?
- Does the proliferation of Corporate Bonds create increased systemic risks that aren’t widely appreciated?
We will focus on point 1. primarily but it is worth touching briefly on 2. and 3. at the end.
Do Corporate Bonds reduce Portfolio Risk?
Since 2000 there have been two significant equity Bear markets, which left many investors nursing losses of 50% or more, which has led many to try and reduce risk through the traditional approach of adding fixed interest instruments, or Bonds, to their portfolios, a process followed by investment/pension fund managers for many decades.
The problem is though and it’s not insignificant. Traditionally the Equity / Bond portfolio mix traditionally espoused has been an Equity / Government Bond mix; an important distinction, because Government Bonds tend to rise when economic conditions deteriorate, and fall when things are good, the opposite of the stock market, so a natural hedge that also pays an income. Corporate Bonds have a more complex relationship, as shown below.
The key to understanding Bonds
Simplifying to the extreme we can imagine a Government Bond that pays the same as the government base rate of 2%. Assume for this example there is no redemption date when capital is returned.
Thus, for each 100p bond there is 2p of income, a 2% yield.
Interest rates fall to 1% and the bond only need offer 1%, so the bond increases to 200p, 2p of income now representing 1%. Interest rates halve, the bond doubles.
Assume interest rates then rise to just 4% in a recovery then to equal a 4% yield with a 2p income the bond must value at just 50p, or 25% of the value at 1%. This demonstrates that even a bond with an assumed government income can be dangerously volatile, particularly in a low interest rate environment, like todays.
(Naturally if the above bond is to redeem in 10 years at 100p, as rates fall to 1% it won’t increase as dramatically as there is a guaranteed loss of capital back to 100p that has to be taken into account. As the bond hasn’t doubled investors gain a higher income yield from the 2p payment to offset a guaranteed loss of capital. A situation faced by many investors in “safe” government debt today. Likewise, should interest rates double the bond won’t fall as much as it will, necessarily, climb back to 100p over time, but will thus pay a lower income to balance the total return.)
Corporate Debt Risk “Spread”
Understandably the above interest rate sensitivity also applies to Corporate Bonds, but with an added twist, specifically the “Risk Spread to Government/Gilt Bonds” or in market colloquialism, the “Spread to Govies/Gilts”.
Put simply company debt has more risk than government debt and thus investor demand higher income in return. Thus, a high-quality company might be issuing bonds at just 1% more than the government, while a struggling company (with a “junk” rating) may have to pay 6% – 10% more than the government. Importantly the size of the “spread” changes as market confidence changes, if investors are bullish, and the stock market high even “junk” debt may be bought with yields only slightly higher than government debt, say at 2%.
The problem is if markets become nervous and investors decide that 10% is again the correct rate for Junk debt. If it now pays only 2p of income should the Bond fall from £1 to 20p to earn that 10% income? While the fall is again mitigated by a final redemption value (assuming the company survives) the Corporate Bond may still fall like the stock market.
This simple risk relationship is demonstrated by looking back at the behaviour of a few funds, all currently held in the portfolio from August 2008, just before Lehman’s, to the point where markets turned in April 2009 against the UK Stock Market (in black C):
Click/Tap to Enlarge
(All charts are in priced in £ as Bid – Bid, Income Not Reinvested, Data: Financial Express Analytics)
You can see that during this period of extreme stock market stress that four of the six Corporate Bond funds fell more than the stock market (with one in-line). Worse during this period interest rates fell, so government debt rallied, meaning the risk spread was increasing dramatically.
We can demonstrate this by filtering the previous chart to include government bonds (A) and two conservative funds the portfolio also holds (B & C):
Click/Tap to Enlarge
(All charts are in priced in £ as Bid – Bid, Income Not Reinvested, Data: Financial Express Analytics)
We see that UK Gilts appreciate during this period, pulling up the conservative funds, even as high-yield funds fall like the stock market. In short, the “Risk Spread” increased so dramatically that even as government interest rates fell sharply, the income demanded on these bonds just kept going up. The correlation to the equity market (E) is clear.
The Golden Age for Corporate Bonds?
As markets began to recover in 2009, helped by zero interest rates and QE, equities bounced back, as did risk appetites benefitting Corporate Bonds that finally also responded to lower base rates. Showing only the best and worst funds (A & C) we can see how bonds could be a better recovery play than (B) the stock market (accumulate the income and the returns are even higher):
Click/Tap to Enlarge
(All charts are in priced in £ as Bid – Bid, Income Not Reinvested, Data: Financial Express Analytics)
The elephant in the room
You can see that since the beginning of 2014 the equity market has been making slow progress, in a volatile channel, as growth prospects, and therefore earnings wane. Bond funds meanwhile have become increasingly flat as interest rates have remained near zero, providing no extra lift (but no negative pressure), while the underlying risk spread is pushed to the limit.
This begs the question of what happens next? If growth and inflation are suddenly back with us (only likely on panic driven epic stimulus) there is little room to compress risk spreads to boost prices, but a real risk that base rates will rise and thus government bond yields will rise, pushing prices down.
If, however we are slowing down then government rates will remain on the floor, which remains supportive, but risk spreads will likely increase as companies start to struggle with debt, driving prices down, perhaps precipitously as occurred in 2008.
Even as they produce less and less income it seems there might be little upside in corporate bond funds so we must briefly address our earlier question 2:
Does the growth of the Corporate Bond sector portend large economic risk?
In short, yes. Taking advantage of low interest rates and income hungry investors companies have taken on more and more debt (which is what the funds hold) in the slowest economic recovery on record.
Worryingly much of that debt has been used to buy back shares, to boost Price Earnings Ratios (PERs) to increase share prices. This boosts corporate pay while weakening balance sheets, making companies (and their debts) more vulnerable in a slowdown.
Furthermore, the quality of this debt, measured by company gearing, is at its lowest in post WWII history, so the danger of “Risk spreads” widening dramatically is high. How these risks have grown is common sense once you understand the basics of the mechanisms at work, yet markets have ignored the problem, begging us to look at our question 3:
Does the proliferation of Corporate Bonds create increased systemic risks that aren’t widely appreciated?
In short, yes it does. Dramatically.
We have seen how these assets can behave just as poorly a stock markets under duress. Yet in a future slowdown few economies can lower interest rates to help boost bond prices so there would be less support in a market sell-off than in 2008.
More worryingly since new banking rules came in following 2008 the banks cannot commit as much capital to make liquid markets with large holding of these bonds, even as the market has trebled in size. Thus, if there is a panic there is a real risk that there will be no market for lower grade debt and rather than just the severe falls witnessed in 2008/9 we could see a Woodford like gating on a significant scale.
If the risk is so high, why are investors so unaware?
There are two key problems, the first is mistaking the Corporate Bond for the Government Gilt in the original Equity/Government Bond model (a mistake few investment fund marketing departments are keen to correct or, in fact, understand). More troublingly we still see this flawed shorthand used on business TV and in the financial press, with no apparent awareness of the underlying reality.
Secondly there is the Modern Portfolio Theory that drives most investor asset allocation models which measures risk only by short term volatility measurements. You can see in the earlier charts many funds behaved in line with the stock market (or worse) over time, but you will note that even the worst performing funds chart a much smoother line than the stock market, even as they fall more.
This smoothness means funds measure as being less volatile than the stock market and thus to the complicated (but wrong) portfolio maths they are measurably less risky, even though evidentially they aren’t over the longer term.
Perhaps more troublingly is that this mathematical approach doesn’t ask WHY markets behaved as they did during a certain period (interest rates fell rather than rose, for instance) nor can it factor in variables such as changes to market liquidity.
Summary
We can see quite simply that the common beliefs driving modern day asset allocations to Corporate Bond funds are flawed to the point they may be adding to both capital and correlation risk in portfolios that, optically at least, appear diversified.
In an ultra-low internet rate environment, with a complacent risk culture (rates are ultra-low for a reason after all) the downside of many portfolios is probably far higher than investors perceive.
This is not to say there is no place for bonds, or bond funds, particularly if income is more important in the short-term than capital preservation, but investors need to be aware of the true risk factors.
Thus, we would argue that a much more cognisant approach needs to be taken to this asset class, which is both fundamentally and mathematically riskier than appreciated by most and this clear naivete, in a sector that has grown dramatically, just as liquidity has reduced dramatically, could be at the heart of a future financial crisis.