Sometimes in investing it pays to simply settle down to the fact that being as boring as possible is often the best way to make money. The year was largely dominated by expectations that yields on prime sovereign debt would start to rise as interest rates slowly climb back to historic levels ('Back to Bond Basics', 23 Jan 2014). We identified what seemed to be an almost universal agreement among fund managers that this would happen this year. However, as the strong performance of sovereign bonds proves, yet again, few investors ever lose money by going against received wisdom. The overwhelming question is still whether sovereign bonds will continue to deliver this kind of outperformance, or are there better value, but riskier options available at the moment in the general bond market?
Not when, not if
Expectations that interest rates would start to rise sooner rather than later have been put back after a torrid autumn of underwhelming economic data coming out of the eurozone. Germany's stalling manufacturers, France's moribund economy and Italy's obvious descent into deflation is ramping up demand for 'safe' assets such as gilts, bunds and treasury bonds.
Taking gilts as an example, the average yield for benchmark UK government debt 10-year gilts fell from nearly 3 per cent in January this year to just 2.21 per cent recently, their lowest running yield since July 2013. Based on experience over the past few years, such price levels have previously indicated that a major squeeze on gilts yields is in the offing.Such a fall is counterintuitive as the UK economy has been a star performer all this year. It seems that bond investors are concerned that a slowdown in Europe will eventually exert a downward gravitational pull on our own GDP figures. In which case, holding government debt, at least in the short term, has a safe-haven appeal with inflation dormant, and falling rapidly, and interest rates not going up as quickly as the market had predicted.
Time to take the US yield?
What the market gives, it also takes away, which can open up interesting opportunities in other asset classes. Analysts at M&G Asset Management recently identified the fact that the high-yield bond market in the US endured its worst quarter in over three years. Yields had been severely compressed by a combination of asset buying by the Federal Reserve and income investors desperately trying to overcome low interest rates. With the Fed reining back on asset purchases and the market looking for security again, the relative performance of high-yield bonds has slipped behind its sovereign counterparts.
According to M&G, US Treasuries have returned 5.5 per cent, investment grade corporate bonds 7.7 per cent year to date, while US high-yield asset has gained only 4.5 per cent, leaving high-yield bonds much better priced. The other noticeable trend in the sector is that many highly leveraged companies have taken advantage of the abundance of liquidity to refinance their balance sheets at lower rates than would otherwise have been the case. This is positive for the high-yield market in two ways. To begin with, lower interest rates means debt can be borne relatively easily, which is why the current default rate in the US market is only predicted at around 2 per cent of total issuance. Secondly, the date at which most bonds have to be refinanced has been pushed back by several years, as a result the high-yield market doesn't face any major need to roll over significant amounts of debt before 2020, says M&G.
What now for Orb?
The UK's own retail corporate bond market has had its fair share of ups and downs since its launch in 2010. The main problem has been attracting enough issuance to prevent the market from shrinking as bonds naturally redeem. The number of bonds issued has fallen back from a high of 16 in 2012 to just six so far this year, although a couple are reportedly in the pipeline before Christmas. There are a number of factors at play that have conspired to slow down the market. Firstly, companies have found it generally easier to access bank debt as the credit crunch has eased, making the need to issue bonds less pressing. Secondly, 2012 was a peak year for refinancing generally as a lot of short-term debt had to be rolled over in the aftermath of the 2006-07 credit boom.
The next round of major refinancing in the UK won't be before 2016 at the earliest, probably at a flat rate of interest if bank rates stay the same, meaning there are far fewer incentives to attempt a bond flotation. It isn't that Orb has performed badly - over £3bn in debt has been raised since its inception and demand from retail investors has been excellent, with all the bonds issued on Orb oversubscribed. The main weakness is still the lack of issuers who aren't property or financial services companies. These sectors come with a natural level of gearing and comprise companies that understand the need to have as many different sources of finance as possible. Any sign that more companies are starting to use Orb to raise finance will show that the market has started to mature, but it certainly needs to show more vigour in 2015 to be considered more than just a qualified success. The ultimate goal would be for Orb to turn something similar to the Italian bond market, where over a €1bn of bonds are traded on a daily basis.
In addition, as companies editor Stephen Wilmot has pointed out (Chronic Investor, 27 Sep 2014), the real test for the market will be when an issue eventually defaults. He notes that the effect on sentiment might be severe enough to frighten off the fixed-deposit investors who are fed up with low bank interest rates and are currently using Orb to generate an alternative source of income.
Mini-bonds booming
Another factor at play might be the seemingly unstoppable rise of so-called mini-bonds. We evaluated the investment case for mini-bonds last year ('Mini-bonds under the Microscope', 29 Nov 2013) and found them to be a generally riskier investment that would be implied by the average income yield of around 7 per cent. Providence is the latest company to market a mini-bond to retail investors. The niche finance company, which specialises in short-term loans to companies, is offering an 8.25 per cent mini-bond in order to raise £25m to provide 'factoring' loans for small businesses. Factoring is a short-term finance option to cover late payment by customers.
Mini-bonds have been issued at roughly the same rate as conventional bonds over the past couple of years and whether this has stopped Orb from issuing more bonds is a moot point. With one or two notable exceptions, mini-bonds have generally been issued by small private companies who do not have the option of issuing equity and whose financing needs are minor compared with the utility or property companies that have used Orb. The relative lack of regulatory oversight is the main worry with mini-bonds and seems to be rarely reflected in the coupon.
EnQuest-ions to answer
The fall in Enquest's (ENQ) bond price is a useful case study into whether Orb bonds are offering a good value safe-haven option to the recently volatile stock market. It is also shows how outside events can affect bonds in the same way as shares. The oil explorer raised a considerable amount of debt on Orb in January 2013 with a 5.5 per cent bond that raised £200m. In the absence of a dividend with the shares, the bond coupon was seen as interesting income alternative to what had been a strongly performing equity.
Unfortunately, the global glut of crude oil has had a huge impact on oil explorers and producers. Below $80 a barrel and most producers struggle to make a living and EnQuest would probably need to pump far more than its current average of 25,000 barrels a day to stay competitive.
The impact on the bond price has been swift. Enquest's bonds now trade at an average price of 90, implying a yield to maturity at current prices of 6.3 per cent. On the face of it, this does not look a bad return for risk, but reflects the possibility that EnQuest is nearing the limits of its debt covenants if the oil price remains at its current depressed level. Given that the retail bond sits behind bank debt in the company's debt structure, it is therefore unsurprising that investors have taken a cautious view and marked down the bonds. Bargain hunters may be tempted, but you would need a firm view on the direction of the oil price before getting involved - and with the Saudis and US producers slugging it out at the moment, clarity, unlike crude oil, is in short supply.
The paradox is that not all Orb oil bonds have performed poorly. For example, the Premier Oil (PMO) 5 per cent is trading back at 99 after falling steeply, but the market has noted the fact the Premier is a much more diversified producer than EnQuest and so has given the company the benefit of the doubt.
What about next year?
There is no doubt that Orb bond investors have had a good 2014. The Orb index has delivered a total 12-month return of 6.3 per cent, including coupons. That compares very well with the FTSE All-Share's 4.5 per cent total return and bond investors can thank easing concerns about interest rate risk for the sudden spike in prices. Orb's structure also makes for relatively stable performance. Retail investors as a group tend to buy and hold bonds until redemption and, while that may raise questions about secondary market liquidity, retail bonds have been far less affected by volatility than the broader bond market. Mark Glowrey, Canaccord Genuity's resident bond expert, says that investors should remember that all bonds are fundamentally range-trading instruments and prices will be determined by the run down to redemption as much as anything else.
Whether that can continue in the face of rising interest rates is a separate issue, but short sterling contracts - the most closely watched indicator for short-term interest rate expectations - shows interest rates increasing to 1 per cent by March 2016, which hardly suggests much short-term risk for Orb bond investors.
