Corporate bonds in demand
In the search for investments with low to medium risk, there has been renewed focus on corporate bonds. These are investments which are often described as the perfect compromise between stocks and bonds.
For decades, government and mortgage bonds have held a unique status in Northern Europe as the stable investment for the sensible investor. This is now being put to the test. Historically low interest rates, coupled with the prospect of modest or even negative bond returns, are intensifying the search for new investment opportunities in the low to medium risk category.
For many, the alternative has been to embark on the stock market; an abrupt transition from still waters to rough seas. Just looking at developments over the past seven months, one can see how high the waves have been. But where else is there to go if you want the prospect of higher returns without quite so much stormy weather?
An alternative to stocks
One option is corporate bonds, where the risks lie somewhere between those of stocks and government bonds. These are bonds issued by companies for which you lend money to the companies. In return, they pay you a much higher interest rate than that offered by the state. This so-called credit spread can vary depending on how creditworthy a company is deemed to be.
"The current credit spread between government and corporate bonds is at a very attractive level," says Ola Sjöstrand, Portfolio Manager of the bond fund SKAGEN Credit. As a result, his fund has generated a return of around 5.9% so far this year as measured in euro (as of 24 August 2016).
In SKAGEN Credit the portfolio managers carefully select companies whose interest rate (credit spread) is sufficiently attractive relative to the risk of bankruptcy. They also make sure to hedge the interest rate and currency risk. The advantage of owning the bonds is that you receive a fixed interest rate from the company (coupon) and, in contrast to stocks, the price does not fluctuate in the same way.
Difficult to do it yourself
There are a few barriers to entry for private individuals looking to invest in the corporate bond asset class. First, you must have some hundreds of thousands of euros at your disposal since you should invest in at least 10-15 different issuers to obtain good risk diversification between sectors and regions. Second, you need to be aware of the companies' ability to be able to pay interest and the principal. In addition, you should hedge the currency and interest rate risk so that it does not affect the return. Finally, you should review the prospectuses of each and every corporate bond in order to find out what your obligations and rights are as an investor if the company is unable to pay interest and principal.
"Given the currency, interest rate and bankruptcy risks involved, as well as the high barriers to entry for private investors, it can be advantageous to let a portfolio management team take care of the investments. Our fund continually optimises the portfolio to ensure a good risk diversification as well as hedging interest rate and currency risk," says Ola Sjöstrand.
The invisible threshold
The fund is actively managed and has a global investment mandate whereby at least half of the fund must have a credit rating of BBB- or higher. Unlike most corporate bond funds, SKAGEN Credit is able to invest in companies with high credit ratings (a credit rating of BBB- or better) as well as companies with lower credit ratings.
In practice this means that some funds are constrained by their mandates and must sell bonds if the credit rating falls below a BBB- rating. Securities where investors are forced to sell have a tendency to fall too much. This creates opportunities for a fund like SKAGEN Credit which is able to invest in attractively priced corporate bonds and hold them until they are rerated to a better credit level.
The portfolio managers do their own analysis and have the possibility to buy bonds with rerating potential; picking them up before they are rerated to a BBB- rating or better. Unlike other funds which must invest in one particular currency, SKAGEN Credit has no restrictions when it comes to currency. This means that a company that wishes to spread its loans between various markets may be willing to pay more to lend in dollars rather than in kroner. The fund can make use of this advantage. SKAGEN Credit has a low duration (around 1 year) and seeks primarily to create returns by taking credit risk and, to a lesser extent, interest rate risk.
The interest in corporate bonds in general and SKAGEN Credit in particular is increasing. Corporate bonds can be worth considering in a balanced investment portfolio.