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Bond of the Week: 21 January 2013

Bonds for 2013?


A reader has pointed out to me that recent Bond of the Week articles are mostly of a defensive posture.  So in this New Year issue, I highlight some potential Sterling bonds to buy for 2013.

First of all, investors looking to buy corporate bonds have to lower their return expectations from the market - for two reasons (1) The super-low government bond yields (2) the recent price run-up in the bond market.

The Sterling Yield map on the right will give readers an idea how low the gilt yields currently are. Ten year gilt yields, marked by the blue line, fetch about 2%. This goes up to only 3% if we stretch the maturity to twenty years (see right, or here).

Remember that this government yield curve represents the return from 'risk free' assets (whether this is actually true is altogether another debate!). To obtain more returns over and above government bonds, one generally needs to take more 'financial risk'. In the bond market, these incremental returns are usually sourced from:

(1) Credit - buying assets that have lower credits (say, BB-) than the UK government. These lower quality bonds have higher yields to attract investors

(2) Special features - like an embedded call option within the bond, which usually require more yields to compensate investors

To understand this concept, look at some of the 'outliers' in the Sterling map. Near the top of the chart is an outlier bond - the  HSBC 9.875% 2018 bond. Why is the yield for this bond so high? This is because the bond has a call feature that is due in 2Q. Investors are expecting the bank to redeem the bond at par, thus buying it now at around 102 may entail minor capital losses. So, this bond is not a genuine bargain, really.

At this point in the credit cycle - which I believe is the most important aspect in investing - finding bargains in the corporate bond market will be exceptionally difficult. This is because investors are highly optimistic and are aggressively bidding assets of all kinds - including bonds.  The past year saw most corporate data points (in blue) moved closer towards to government yield curve. A narrowing spread suggests that investors are not as well-compensated as before - even though they are buying the same company with the same credit risk.  Look at the high yields in the US. It has collapsed to multi-decade lows (see a discussion here).

However, finding a reasonable bond to invest in for the medium term is still possible. From the Sterling yield map, it appears that the greatest spread relative to the gilt yield curve is observed at around 2020. This means that we are looking at Sterling bonds with seven year maturities. A quick flick through the data point shows some interesting picks:

  • GKN 6.75% 2019 (yield 4.05%) - just broke out of the medium term sideways range; near-term target 116 (although we recently took profits in our model portfolio).
  • Goldman Sachs 5.5% 2021 (yield 4.36%) - broke the 100 lateral resistance and is amidst a price uptrend
  • FirstGroup 6.125% 2019 (yield 4.48%) - is rangebound but offers the potential for an upside breakout
  • AXA 7.125% 2020 (yield 4.44%) - is trending upwards steadily, thus offering more near-term upside

The first thing to note from these bonds is that their yields are not high. This is because many of them have rallied strongly in 4Q last year (see below).

View: Bond markets are highly cyclical. Therefore, when investing in this market readers better pay attention to the current point within the credit cycle. Right now, it is obvious we are in a bull market in bonds and stocks. Many financial instruments have rallied significantly over the past year, putting them well out of the definition of a 'bargain'. The above corporate bonds may produce reasonable, but not spectacular, returns in 2013. As it often said, "well bought is half sold", I certainly would not be too aggressive in buying corporate bonds at this point in the credit cycle, although putting some cash to work (for around 4%-4.5%) is a workable idea. Some new retail bond issues may also have attractive returns, but it will be a case by case basis.        

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