Fears over a potential liquidity crisis in the corporate bond market are “significantly overblown”, according to Adrian Hull, head of core fixed income at Aegon Asset Management.
With interest rates continuing to rise as central banks strive to tackle persistently high inflation, concerns have mounted that corporates could struggle to refinance the cheap debt they accumulated over the past decade.
However, Hull says that while corporates, and non-financials in particular, have borrowed heavily in recent years to take advantage of low rates, they have already taken action to protect against rising interest costs, principally by terming out the debt. As a result, both lower yields and longer-tenor bonds have increased the duration of average corporate bond indices in recent years.
“There is no doubt that refinancing will start to increase the cost of debt to corporates, but much like in the current debate on the cost of UK mortgages, the path to the ‘pain point’ is much slower than we might have expected,” he says.
“Typically, the crunch point for weaker corporates has been around refinancing, but this is not an issue for high yield. Although it remains realistic to see an increase in defaults from the low levels witnessed over the past few years, high yield markets are not currently pricing a step change in defaults.”
Credit markets have enjoyed solid performance so far this year, and while Hull anticipates a less supportive environment may be on the horizon due to higher rates and sluggish or slowing economies, he does not envision a cliff edge.
“Investors typically worry about bond market liquidity while ignoring the self-healing prospect of higher yields,” he says. “It is easy to worry about liquidity in open-ended funds, but these fears are unfounded when the majority of activity in bond markets is related to insurance companies or pension schemes, where active allocation to bond markets repriced at higher yields becomes attractive.
“At Aegon AM, we have over the years identified issues around the post-financial-crisis structure of liquidity in markets, but we feel far more confident that the ‘value’ and liquidity in markets today is supported by current yields not seen for over 15 years. Mutual funds in European investment grade markets have all increased over the last 12 months.”
Far from exhibiting a “mini-budget-style” panic, Hull believes that bond markets are continuing to function well despite elevated fears over a liquidity squeeze – and that the ending of the Bank of England’s corporate bond sales programme should give grounds for confidence.
“There are always concerns about a breakdown of market conditions or liquidity squeezes, but given where markets are pricing today, we do not foresee a ‘mini-budget-style’ event in corporate bonds. Investors worry about hidden risks, but what’s notable today is the ongoing function of the corporate bond market.
“Central banks remain a key component of the bond market. Less talked about than the headline interest rates is the resale of bonds by the Bank of England. Investors worried last year that the £20 billion sale of corporate bonds amassed by the Bank would be a material drag to the market.
“Those bonds have been sold back to the market, and the market has rallied into that material supply. On top of this, the Bank no longer reinvested in Gilts and is now actively selling them. This is not the activity of a non-functioning bond market.”
