Steep declines in corporate-bond prices present an opportunity to turn a profit while earning juicy interest rates, some fund managers say. Large swathes of the corporate bond market are trading at a discount to face value, a dynamic not seen since the depths of the financial crisis 10 years ago.
Rather than a sign of impending doom, however, some investors see a unique opportunity to buy bonds with significant headroom for capital appreciation. Rising interest rates and the Federal Reserve’s shrinking balance sheet have sent shudders through the bond market.
Companies are finding it harder to raise new debt, regulators have expressed concerns about risks to financial stability, and investors have been burned by steep declines in the price of bonds issued by firms such as General Electric Co. But declines in the face value of bonds has also created a pricing dynamic that can make bargain hunting especially attractive.
In October and the first half of November, around 70% of U.S. investment-grade corporate bonds traded at or below face value, according to analysis of market data by MarketAxess, an unusually large proportion outside of a recession. In a period of rising rates, fixed-rate bonds that were issued at lower yields tend to decline in value in relation to newly issued bonds, which sport higher coupons. Slowing economic growth, which could lead to skimpier corporate cash flows, also worries bond investors.
When bonds trade below face value, there is more upside in case the bonds are redeemed early by the issuer or sold on to another investor at a higher price.
Investors in general neglect bond prices and their potential to appreciate, says Fraser Lundie, co-head of credit at Hermès Investment Management. Sectors that are fertile for mergers and acquisitions—such as construction, telecoms and media—are particularly appealing when bonds are trading well below face value since they tend to contain put options that can be exercised at or above par in the event of a deal, he added.
That’s partly why Hermès recently bought bonds issued by home construction company Toll Brothers. Callable bonds are growing in appeal as interest rates rise and prices fall. These let the issuer buy back bonds before they mature. The further bonds trade beneath the price at which issuers are able to buy them back, usually just above par, the bigger the payoff if they do decide to repurchase. Moreover, investors whose bonds have been bought back may be able to put their money to work at higher yields elsewhere.
The share of the bond market that is callable boomed after the financial crisis. When interest rates were falling to record lows, callable bonds gave issuers the chance to refinance the bonds if borrowing costs continued to drop. According to Dealogic the share of newly issued investment-grade bonds that are callable shot up from 61% in 2008 to 91% in 2016. It has hovered near that level since.
Regardless of the pricing quirks, some fund managers simply think the bond selloff of the past few months has gone too far.
U.S. corporate debt, especially at the lower end of the investment-grade spectrum, from firms that run energy pipelines, and from financial firms, is a favorite of Jeremy Cave, managing director of global fixed income and liquidity at Goldman Sachs Asset Management . He thinks company balance sheets are generally strong, and that the American economy is unlikely to enter recession until 2020 at the earliest.
François Bourdon, global chief investment officer at Fiera Capital, a Canadian asset manager, has dipped into two companies with particularly discounted bonds: GE, which has been beset by problems at its power unit, and electricity provider PG&E Corp. , which faces liability for equipment that may have caused Northern California’s deadly Camp Fire. He doesn’t intend to hold the positions for long, but felt they were oversold.
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To be sure, investors may find obstacles even if they do find bonds that appear to be trading at bargain prices. At times it has been a struggle to find sellers as well as buyers of corporate bonds, said Mr. Cave of GSAM, adding that derivatives such as credit-default swaps are more liquid but don’t offer value compared with cash bonds.