Fidelity's Ian Spreadbury shares his views
Sterling investment grade credit spreads are at their widest level in over two years. A combination of weaker economic indicators and continued fear of a European sovereign default has weighed on the corporate bond market. However, with companies still in good shape, does the recent sell-off present a buying opportunity for corporate bond investors? Ian Spreadbury, manager of the Fidelity Strategic Bond Fund, gives his latest assessment in this Q&A session.
Is now the right time to increase exposure to corporate bonds?
Non-financial corporate bonds seem to be good value; corporate balance sheets remain healthy despite credit spreads widening. Our quant models, which consider economic fundamentals, market liquidity and sentiment, have confirmed this - all our models are giving buy signals. And those models that focus on tactical asset allocation suggest that I should beef-up my exposure to credit. But although models are helpful indicators, the real world is more complicated than theoretical constructs.I believe we have seen the peak in credit fundamentals and that the weaker growth environment will cap any further improvement in corporate strength. Profit margins are likely to be squeezed by rising input prices, which might remain stickier than expected, particularly if we get more quantitative easing. Falling margins reduce the ease with which companies can service their debt. This is a negative for corporate bond investors, but at this point I expect fundamentals to weaken at the margin rather than decline dramatically.
Where do you see value?
On the plus side, there are attractively priced companies that can offer some resilience to poor economic conditions. Last week, I picked up a 7-year Imperial Tobacco bond and an 11-year Tesco bond both on yields of over 4.0%; that's almost double the yield on gilts with the equivalent maturity. I think these bonds offer a good balance of risk and reward given the uncertainty surrounding the UK's fiscal sustainability and the defensive qualities offered by tobacco and food sectors. The other areas I favour are pharmaceuticals, transport, consumer staples and utilities - all contain companies that have a degree of pricing power in a tough operating environment.
Investors remain highly sensitive to the political events unfolding in Europe as EU leaders try to restore confidence. Whilst spreads may appear good value, risk aversion may drive investors to sell credit in favour of safe havens such as Gilts (see graph above). The key is to remain diversified and in particular, not to be over concentrated in financials. Financials remain the largest source of volatility in the market since their abilities to operate are threatened by the risk of a eurozone sovereign debt fallout. Overall, I expect to increase the Fidelity Strategic Bond Fund's exposure to corporate bonds over the coming weeks, although the move will be gradual as the market remains risk averse.
What other changes are you making to the fund?
In August, I realised profits on my UK and US inflation-linked bond positions as real yields (the yield on inflation linked bonds less inflation) moved negative for the first time ever. I held around 8.0% of the portfolio in these bonds for about a year. However, I recently moved back into these securities as breakeven rates (the difference between real and nominal yields) fell significantly. Markets are pricing-in declining inflation due to a global slowdown, but they might have taken it too far. Inflation over a medium term horizon still warrants some protection (5-10yr), so the fund's allocation in this space (7.0% of the portfolio) adds diversification.
I expect central banks to engage in more monetary stimulus as the growth environment weakens. Nominal GDP growth is required to avoid a debt deflation spiral; the worst possible outcome for indebted economies. With developed economies pursuing austerity measures and a potential fall in emerging market demand, we can expect real growth to remain low, placing downward pressure on inflation. Meanwhile, central bankers will likely revert to quantitative easing to boost nominal growth through higher inflation, although perhaps in a slightly different form.
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