Bonds 'less attractive' when rates rise.

Byline: ANDREW MILLER 

CORPORATE bonds have enjoyed a strong rally since markets found their feet in early March. However, just like ordinary Government bonds, fixed-rate corporate bonds should look less attractive when interest rates eventually rise.

Additionally, corporate bonds face different risks compared to Government bonds: they are affected by the market's perception of the credit worthiness of the issuer over and above the market's demand for income (or yield). However, improving corporate fundamentals - such as improving corporate earnings and profitability - can overcome the negative effects of rising interest rates to help such investments deliver robust returns.

In theory, better-rated corporate bonds should be more adversely affected by rising interest rates than riskier bonds.

Part of the reason is that companies that remain better rated after a dip in the economy do not have that much more room to improve further when compared to riskier bonds - such as high-yield issues - that were shunned by investors for being too dangerous during the downturn, and which might perform better as the economy recovers. In practice, however, this effect is complicated by other issues (such as defaults and levels of leverage) which can have an impact on low-rated corporate bonds.

So, what is the prognosis from here? As far as the outlook for high-yield debt is concerned, it is worth noting that the current cycle has seen default rates rise close to peak levels already.

Moreover, high-yield debt has outperformed investment-grade debt, and tighter monetary policy does not seem an immediate prospect, which should help the asset class.

By historic standards, high-yield debt continues to offer a decent pick-up in yield when compared to Government debt of the some maturity. It's also worth remembering that high-yield bonds tend to be of shorter duration (or shorter weighted-average maturity) than investment-grade bonds, and this means that they should not suffer too much when interest rates do begin to rise from what are very low levels.

As for good-quality or investment-grade corporate bonds, we believe performance will be driven largely by spread tightening (the "spread" being the difference between a corporate bond yield and a comparable maturity Government bond yield, which reflects the level of credit risk associated with the issuer).

Since investment-grade spreads are lower than high-yield spreads, it is important for investors to establish which specific sectors or maturities offer value. Spread curves tend to be upward sloping as investors tend to attach a higher probability of a company defaulting in, say, 10 years as opposed to five. However, in stressed conditions or for stressed/distressed issuers, spread curves can "invert", i.e. a higher spread is demanded for shorter-dated bonds versus longer-dated bonds from the same issuer.

While many such inverted curves have disappeared, the anomaly persists in some sectors within the investment-grade universe. Indeed, even from just a spread perspective, we believe that short-medium maturity investment-grade bonds look more attractive than longer maturities. For financials, the one to three years and five to seven years maturities look attractive in our view, while for non-financials the five to seven years maturities seem to offer the most value.

So, as is so often the key in investment, sound sector and security selection is likely to be key in the investment-grade debt universe as markets look towards the day when interest rates inevitably begin to rise from their near-zero levels.

Andrew Miller is regional office head at Barclays Wealth in Newcastle