- Significant extra return compared to government bonds
- High inflation may lead to more rate hikes in the Eurozone
- BRIK corporate bonds offering average yield of 8.4%
The crisis that gripped the financial sector from mid-2007 is still not over yet. Investors" risk aversion has increased substantially, leading to a sell-off for all classes of riskier assets. Thanks to yield premia which are currently high by historical standards, corporate bonds with excellent to average credit ratings now represent an attractive alternative to government bonds. Given the present interest rate conditions, funds with a selection of high quality corporate bonds and good issuer diversification can generate returns between 6% (Europe) and 8.4% (BRIK countries).
Inflation triggers another rate hike in the euro area
Worries about recession faded after the decisive rate cuts by the US Federal Reserve Bank, the massive injection of liquidity at the global level and the bail-out of the US investment bank Bear Stearns. Events now are increasingly dominated by the mounting rates of inflation, as Eurozone prices rose 4.0% in June, a pace well higher than the European Central Bank"s target of 2.0%. In reaction to this, government bonds have come under strong selling pressure since the end of March. Yields on 10-year German bond rose accordingly from 3.7% to the current level of around 4.6%. As a result, funds which primarily hold government bonds in the portfolio have posted rather disappointing performance so far this year. The central banks in both Europe and the USA are obviously concerned about the rapid pace of inflation and have announced their intentions to take countermeasures. "This means that there is no leeway at all for any more reductions in interest rates", says Franz Gschiegl, managing director of ERSTE-SPARINVEST "Investors should be prepared for interest rates to rise. In the USA, the first rate hikes are expected in 2009."
Money market rates currently higher than for long-term government bonds
The expectations of rising key rates and banks" keen need for liquidity are reflected in the high interest rates on the money markets. The current 3M Euribor is at almost 5% and thus exceeds the yields offered on long-term government bonds. This inverse yield curve in the euro area forms a poor basis for a consolidation in the European banking sector, as credit institutions are faced with very expensive refinancing conditions on the money market. The situation is somewhat different in the USA: due to the large cuts in US interest rates, money market rates are lower than those on long-dated government bonds. This has facilitated a recovery in the US banking sector.
Importance of corporate bonds on the rise worldwide
The corporate bond market has grown to become an important alternative to credit-based financing. At the moment, bonds with a total underlying volume of EUR 2,246 billion are outstanding in Europe and the USA. Some EUR 1,761 billion of these bonds are classed in the "best" investment grade, with the volume of high yield bonds amounting to EUR 485 billion.
Corporate bonds involve two factors which influence the development of prices: the macro-economic conditions and the risk component, which is intended to offer an additional return over and above that on "risk-freeﾔ government bonds. Investors who chose to invest in corporate bonds right now can earn a significant extra return compared to government bonds, thanks to this higher risk premium. For investment grade bonds in the euro area, this risk premium is currently at 1.8%, and is substantially higher for high yields, at 5.5%. "Over a period of 5 years, these rates reflect a default probability of 6% for investment grade bonds and more than 30% for high yield bonds," noted Gerhard Beulig, head of Corporate Bonds and Emerging Markets. For high yield bonds, the "default rate" that is priced in is as high as it was during the worst 5-year period, and for investment grade instruments, it is actually three times as high. "Even though the markets are uncertain about the developments going forward, these rates still reflect an unusually high degree of pessimism, which we do not really find justified," explained Beulig.
Overview of corporate bond markets
Europe
Due to relatively modest to weak economic growth in conjunction with above-average inflation rates, the topic of "stagflation" has returned to the limelight as a major talking point for analysts. Central banks are facing a dilemma: raising interest rates would add more negative pressure on economic growth, but on the other hand, in light of their mandate to preserve currency and price stability, central bankers can no longer afford to sit back and watch inflation rise further without taking action. As a result, central banks around the world are expected to lean more towards rate hikes.
With the exception of the banking sector, the fundamental position of companies in the euro area is better than expected. Due to the relatively high inflation and the latent uncertainty, however, consumption is suffering in the Eurozone"s most important economies such as Germany and France, according to Peter Varga, team leader for corporate bonds.
Fund tip:
ESPA BOND EURO-CORPORATE (ISIN AT0000724216 A)
This fund is invested in European corporate bonds with excellent to average ratings. The ratings of the bonds are in the investment grade range (AAA to BBB). The average return on the securities in this fund is 6.1% (as of 30 June 2008). Authorised for sale in AT, CZ, DE, IT.
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USA
As in Europe, conditions in the USA are also mixed. The decline in US house prices, which triggered the banking crisis about a year ago, is continuing with no signs of slowing down. Consumer confidence is at a 30-year low. The US central bank left the key rate unchanged at 2.0%, but has stressed the risks related to rising inflation. Low interest rates and the weak US dollar are boosting sales opportunities for US firms on the global markets.
Fund tip:
ESPA BOND USA-CORPORATE (ISIN AT0000675764 A)
This fund is invested in corporate bonds with excellent to average ratings (investment grade), which are traded in US dollars. The currency risk in US dollar is continuously and completely hedged against the euro. The average return on the securities in this fund is 6.5% (as of 30 June 2008). This is supplemented by hedging returns, which currently amount to 2.2%. Authorised for sale in AT, CZ, DE, IT.
ESPA BOND DOLLAR-CORPORATE (ISIN AT0000721543)
This fund is invested in corporate bonds with excellent to average ratings. The ratings of the bonds are in the investment grade range (Aaa to Baa3). The bonds are denominated in US dollars. The average return on the securities in this fund is 6.5% (as of 30 June 2008). Authorised for sale in AT, CZ, DE.
Emerging Markets and BRIK countries
The US financial crisis has not really had a severe effect on the Emerging Market economies so far. The stock markets, however, have been impacted, with strong downward corrections seen in some countries. But thanks to the high commodity prices, booming consumption and major infrastructure development, rates of economic growth have remained robust. The fundamental position of companies is outstanding, and the credit rating improvement in Brazil to investment grade underlines, for example, the increasingly stable political and economic situation, compared to previous years. "Companies in the BRIK countries are characterised by strong profit growth and low levels of debt. We recommend including BRIK corporate bonds for diversification,ﾔ said Varga.
Fund tip:
ESPA BOND BRIK CORPORATE (ISIN AT0000A05HQ5 A)
This fund is invested in corporate bonds from the Emerging Markets, with at least 50% of investment in Brazil, Russia, India and Kazakhstan (BRIK). Up to 10% foreign currencies are possible. The average return on the securities in this fund is 8.4% (as of 30 June 2008). Please note: only available in Austria.
Financial terms: What are corporate bonds?
A bond, also known as a debt security, is a written promise to pay issued by a debtor, which can be traded in the form of a security on an exchange. Generally, with bonds it is precisely defined how much interest the investor will receive annually and when the bond will be repaid.
The debtor, i.e. the entity which receives the money from the bond, is also called the issuer. In many cases, this may be a government, which needs capital for infrastructure measures, for example, and finances the interest and redemption of the bond from tax revenues. Such bonds are referred to as "government bonds".
Along with the government, there are also other kinds of debtors, such as companies. Companies may need funds for example to finance a production plant or ongoing operations. Accordingly, repayment of the bond depends on the performance of the company. A bond issued by a company is called a "corporate bond".
Because servicing of the bond depends on the business performance of the company, corporate bonds are ranked as more risky than government bonds. The creditworthiness of companies is continuously reviewed by financial analysts and presented in the form of "ratings". The best rating is "AAA" (triple A), which is issued for countries such as Austria and Germany. For the range AAA to BBB, the term "investment grade" is used, expressing excellent to average creditworthiness. Credit ratings in the range BB to C are assigned for "high yield" bonds. In general, one can say that the lower the credit rating level, the higher the interest rate that the company has to pay on the bond. The yield premium exhibited by corporate bonds in comparison to government bonds is also called the "spread". This premium is intended to cover the risks, which an investor accepts compared to government bonds; in extreme cases these risks can even involve suspension of interest payment or failure to repay the capital invested. A delay in payment or a failure to pay is also called a "default".
With investments in corporate bonds, investors should thus be aware that they are not getting higher interest rates "for free". The higher interest rate is the price paid for the additional credit risk.
ERSTE-SPARINVEST, the asset management company of Erste Bank and österreichische Sparkassen, currently manages a fund volume of almost EUR 28 billion, and is the Austrian market leader in the field of retail funds, with a market share of 24%.
ERSTE-SPARINVEST, Media and Public Relations
1010 Wien, Habsburgergasse 1A,
Telefax: 0043 (0) 50 100 DW 17102
Dieter Kerschbaum, Tel. 050 100 Ext 19858,
e-mail: dieter.kerschbaum@sparinvest.com
Regina Haberhauer, Tel. 050 100 Ext 19860,
e-mail: regina.haberhauer@sparinvest.com
ERSTE-SPARINVEST Kapitalanlagegesellschaft m.b.H.
Registered in Vienna, FN 81876 g, Commercial Court Vienna, DVR 0550922
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