Get into corporates - but not in Asia
Sunday 23 November 1997
As the collapse in Asia's markets caused stocks to fall around the world, and investors flocked to government bonds for safety, corporate bonds did not benefit as much. Investors feared the turmoil in Asia would undermine corporate profits. Generally, investors expect higher yields from corporate bonds than from the comparable government bond in order to compensate for the greater risks of companies. The difference in yield between the two is the spread - a wider spread indicates that corporate bonds are cheap compared with government bonds, and the higher yield on the corporate bonds means their price is lower.
Most yield spreads between government and corporate bonds widened during the rout, creating an opportunity to buy cheaply that is not expected to last long. Spreads are expected to narrow to reflect accurately each company's ability to meet its obligations. Prices will rise as investors buy to boost portfolio returns.
"Corporate bonds are very cheap compared with government bonds right now, so it's a good time to buy," says Rolf Ehrensberger, a fund manager at Swiss Reinsurance. "If interest rates stay low, and I think they are now, then people will be forced to buy corporates to enhance their income."
Also making corporate bonds look more attractive is the advent of monetary union in Europe, which is causing yields of European government bonds to converge.
Corporates favoured by investors include Coca-Cola Enterprises, General Electric Credit Corp and Banque Natexis. In the past two weeks, Mr Ehrensberger bought Eurobonds from Coca-Cola and GECC because the bonds were "extraordinarily cheap," although he would not reveal the spreads at which he bought .
Both companies are familiar to retail investors who buy their products. That reinforces investors' beliefs that these companies will be able to meet their obligations, so they're likely to buy the bonds, too. "Everyone knows these issuers," Mr Ehrensberger says. "GE is a top quality company and no one will question if you buy these bonds for an individual investor's account."
In September, Coke sold $500m (pounds 300m) of five-year bonds at a yield 37 basis points higher than US Treasury bonds. The spread recently widened to 63 basis points, as price gains on Treasuries outpaced gains on Coke's bonds. It's now at 54 basis points. If the spread reverts to the level before the market turmoil of between 36 and 43 basis points, the bonds will see price gains.
In the same period, GECC's bonds actually improved their value. In June, GECC sold pounds 100m of five-year Eurobonds at a spread of 12.5 basis points more than UK government bonds. That spread fell to 2 basis points under UK government bonds - meaning investors considered GECC a better risk than the British government. The spread has since widened a bit, putting the yield on the GECC bonds at 7 basis points more than gilts.
Another corporate bond that offers value is the recent issue from France's Natexis, denominated in dollars, says Gary Jenkins, credit analyst at Barclays Capital Group. Its spreads should be narrower because repayment is guaranteed by the French government.
The opportunity in corporate bonds opened up when stocks began falling in Asia. A 10.4 per cent plunge by Hong Kong's Hang Seng index on 23 October set off a global drop in shares that drove investors into government bonds. So one place not to look for value is among the bonds of companies based in Asia or doing a lot of business in Asia. They will be threatened by any further turmoil.
The effects are showing up already. The spread on Korea Electric Power's global bond due in 2003 and denominated in dollars has jumped to 347 basis points from 103 basis points on 30 October. That is a clear warning that investors should choose carefully what they buy.
It helps to look at credit ratings from services such as Moody's Investors Service and Standard & Poor's, which assign rankings on a company's ability to meet its obligations. The ratings help determine the accurate level of the spread and whether a bond's price is correct. Investors should combine the credit service's analysis with their own to determine whether a company's bonds offer good value.
While investors are buying corporate bonds again, spreads may not return to their pre-crisis level until next year - which means that now may be a good time to buy the better-quality bonds at the wider spreads.
"I'm not sure if spreads (in general) will narrow much before year-end, because I'm not convinced that we won't see further trouble in Asia," says Mr Ehrensberger. "But I'm a long-term investor and I'm happy to sit it out."
Outside Asia, those companies with exposure to the Far East will be most affected by the rout. "Western economies are growing well, so the impact on domestic credits wasn't that negative," says Will Hay, head of bonds at Standard Life Assurance. "There will be some disinflation, because of what's going in the Pacific Rim, for companies which have operations or sales there."
The trend of European investors buying corporate credits to enhance returns helped to keep some spreads in check during the rout, says Jeremy Cunningham, manager at Flemings Investment Management. Mr Cunningham, a choosy investor, also holds a bond from GECC - its 5.5 per cent seven-year bond denominated in European currency units. "It's a solid, good-quality company and we've profited from holding its bonds," he says.
Copyright: IOS & Bloomberg
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