Corporate Bonds - What are the risks?

In this month's Fundamentals briefing, Legal & General Investment Management (LGIM) Credit Strategist, Ben Bennett, examined three broad risks facing corporate bond markets in the year ahead and how investors might navigate through them successfully.

"Last year was exceptional. We cannot expect corporate bond markets to deliver strong double-digit returns again in 2010. Nevertheless, the market backdrop is supportive for credit. Companies have cut costs, the economy has troughed, governments are likely to keep stimulus in place and the financials sector is now generally profitable." Ben stated.

With the likelihood of smaller price movements this year, Ben explained that investors will need to hold higher yielding bonds in order to generate the best returns. "Given a more supportive backdrop, corporate bond investors would be giving up a lot of potential yield by playing it safe."

Ben also outlined three main risks to this positive outlook; an economic boom, an economic double dip and sovereign credit risk. According to Ben, "a strong economic recovery would initially be seen as supportive, yet safe, low yielding non-cyclical companies are likely to be vulnerable to rising government bond yields. Alternatively, another period of economic weakness would threaten issuers who are reliant on the consumer sector. Also, there is a risk that the market becomes uncomfortable with the amount of debt governments have taken on since the financial crisis".

In response to these risks, Ben suggested a number of strategies for investors to potentially extract the best gains from corporate bonds while shielding against these ‘tail-risks'. "One of our strategies involves buying subordinated bonds to pick up the extra yield, protecting us from higher yields should the economy boom, while simultaneously purchasing insurance - through the credit default swap market - on senior financials in case sovereign credit risk materialises".