Friday, December 14th, 2012

More than a Halfway House

To an old equity hand such as “yours truly”, corporate bonds always appear a boring and rather complex asset class. Large multi-national corporations issue a bewildering array of bonds with different maturities, coupons, currencies and contractual terms. There is a built-in tendency for investors to divide the asset class into ever smaller units and not bother about the big picture.

So why talk about them? Answer: because both the US and the Eurozone multi-asset models have built up a large exposure to them in recent weeks. In both regions benchmark (i.e. US & German) government bond yields are too low to provide any sort of income in real terms, and equities are still shaking off the effects of the surge in volatility during the summer. Investment Grade corporate bonds are the natural halfway house at this stage of the cycle – so runs the conventional explanation.

We agree, but we think that there are other forces at work. Our model makes no distinction between financial and non-financial issuers. This naïve approach allows it to capture the recent reduction in the risks attached to financial issuers, particularly those exposed to the threat of a Eurozone break up. And herein lies an important signal for the future of European equity markets. Financials are the most preferred sector in our US equity sector model. Their journey to the top started about a month after we began to see a big increase in the weight of corporate bonds. If the same timetable applies to Eurozone financials, they should reach the top sometime around the turn of the year.

The other argument against the halfway house theory is a straight forward quality issue. Investors can now buy a ready-made portfolio of investment grade bonds via ETFs, based on any of the leading indices. These indices tend to be much less volatile than the government bonds which acts as their benchmark. A combination of lower volatility and higher yield is pretty compelling, especially when the (non-financial) companies that issue them are often more credit-worthy and more diversified than their host governments.

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