LONDON Jan 22 Widespread enthusiasm for corporate bond investments in 2009 is starting to look like hype, and investors should inject some caution into their outlook, said Andrew Sutherland, head of credit at Standard Life Investments (SLI).
"This is more of a curate's egg than a golden goose," he told journalists at a briefing on Thursday. SLI manages some 43 billion pounds ($59.24 billion) in fixed income assets and is one of the top five UK fixed income managers.
Corporate bonds have attracted a lot of attention from investors in recent months as spreads seem to have widened out beyond the likely risk of default.
Sutherland said that with bank base rates heading towards zero, and continued equity market volatility, retail money is now moving in to corporate bonds which seem to offer low volatility and a higher income than gilt yields or cash.
But he warned that problems in the banking sector are likely to keep spreads wide for some time, so in the medium term there is little possibility of capital gains. In bond markets, prices rise as rates, or yields, fall and spreads come in.
Sutherland also warned of concern about the amount investors would recover in the case of corporate defaults, which SLI predicts will continue at higher sustained levels than in recent times.
"For Lehman bond investors, the recovery rate was about 10 cents in the dollar, and for some of the big SIV unwinds it was 15 to 20 cents in the dollar," he said.
Historically, the recovery rate has been about 40 cents in the dollar, and Sutherland is concerned this is still being used to assess the attractiveness of current bond spreads. "We think it is going to be lower," he said.
The subordinated bank debt market is already in disarray following Deutsche Bank's (DBKGn.DE) December decision not to call a lower-tier 2 bond in January due to cost reasons -- the first major bank to make such a move.
"The market had been discounting early repayment for a lot of subordinated bank debt so this sent prices down...All the subordinated tranches are now trading very cheaply," he said.
Subordinated bank debt had been popular with some credit managers up to Sept 2008, as spreads widened out to their March levels and the top tier names were seen as unlikely to go bust.
But the Deutsche decision to delay repayment until final maturity has flummoxed the market. Those managers who held less subordinated debt have performed better, as they have not had to mark to market.
"We had only a modest exposure to subordinated bank debt, owning mostly lower tier 1 and senior, but some investors have large holdings in subordinated capital," said Sutherland. "That is dead money at the moment, without government support." He estimated that some 40 billion sterling of debt is at risk.
He added that although SLI had no exposure to U.S. brokers last year, it was starting to build exposure to some of the big banks now.
He is also targeting telecoms and utilities -- regulated names such as E.ON (EONGn.DE) and General Electric (GE.N), as well as France Telecom FTE.PA and Telecom Italia (TLIT.MI).
He is less keen on Deutsche Telekom (DTEGn.DE) as it has been more acquisitive, he said. (Editing by David Cowell)