Low risk/return levels for riskier high yield bonds have prompted M&G Investments’ Richard Woolnough to increase his allocation to the investment grade corporate debt ever. 
FE Alpha Manager Woolnough (pictured), who oversees a number of fixed income strategies including the £23.2bn M&G Optimal Income fund, said that while central banks are moving towards normalisation of rates, it remains a “low yield world”.
“We will find more attractive duration opportunities in the US than we will in Europe or UK,” said Woolnough, as the Federal Reserve continues to lead its peers in hiking rates.
As such, the M&G manager is taking a “back to basics” approach to bond investing.
While many in the bond market believe the wide credit spreads of late 2007-onwards are here to stay, Woolnough believes they are likely to return to the pre-crisis levels of 2004-2006.
“Why? Because the numbers are there – generally speaking. You are being overcompensated for taking these risks,” he explained.
However, he said there are key differences between the US debt markets and those in the UK and Europe.
“The natural thing for a bond manager to do is to take more risk,” said Woolnough. “They say ‘okay, I will buy lots of risky assets because the return is going to be strong’. But you have to look at what is priced-in.”
As such, the manager said he has been paying much closer to the risk-free spread in different parts of the debt market.
This has led the FE Alpha Manager to become more bullish on investment-grade debt, as high yield bonds aren’t nearly as attractive as they used to be.
Indeed, Woolnough said investment grade corporate bonds were “excessively attractive” compared with high yield debt.
“The probability of a default on a BB bond is a multiple [of investment grade debt], so I should get paid more,” he said. “Liquidity on a BB bond [is lower], so I should get paid more. But I don’t.
“Historically this has been a more attractive area, [however] the main driver behind [this low risk-free rate] is a lack of supply.
“We have talked [in the past] about higher supply in high yield but there has been a lot of supply of BBB bonds.”
Greater issuance of debt in the investment grade part of the market has led to greater merger & acquisition (M&A) activity, such as Sky’s takeover by Comcast.
“If there is huge amount of supply, when that huge amount of supply comes, the bonds trade historically wide versus where they should,” he explained. “This has nothing to do with the probability of default and nothing to do with liquidity, it is just due to supply. And that’s the nearest you can get to ‘free money’.”
Bond issuance 1996-2007
Source: SIFMA
As such, Woolnough said he wants to make sure he owns the issues likely to benefit from increased takeover activity.
Indeed, the M&G Optimal Income currently has 48.5 per cent in investment grade corporate bonds, compared with 26.3 per cent in government bonds and a 12.3 per cent in the high yield sector.
However, the manager noted that supply dynamic seen in investment grade corporate bonds will eventually change and investors will see a reduction in this type of issuance.
“We have seen Comcast cancelling their buy back and Verizon tried to buy their bonds back earlier this year as well,” said Woolnough.
“Companies buy back debt to buy back equity because that’s how they make their shareholders wealthy. The only reason they do it is because debt was cheap versus equity,” he said.
“If debt becomes expensive versus equity you want to borrow less and if it’s cheap you want to borrow more. But it is getting expensive for US companies to borrow: short rates are 3 per cent and long rates are getting towards 4 per cent.”
The bond fund manager added that as the M&A cycle disappears there will also be a shrinking level of investment grade bond issuance.
“If companies don’t need to issue and yields are high then they don’t and the supply will fall,” he noted.
However, 2018 hasn’t been a great year for the fund – which is down by 1.75 per cent this year, so far – the manager admitted, with some contradiction and different views amongst the M&G fixed income team and markets.
“One of the pleasures of being a bond fund manager is that when we have a strong view and economic recovery is around the corner, [there is] very short duration and lots of credit risk [that] is when the market agrees with us,” he said.
“And when the market decides recession is around the corner we look like a poor asset manager.”
Currently the team have taken longer duration within the portfolio, as they believe the Federal Reserve is “behind the curve” and that rates will have to rise a lot sooner than anticipated.
Woolnough explained: “If the Fed is behind the curve we get exactly what we are getting now: inflation above target, rates not being where they are and the hottest labour market we’ve had in three years.”
Given the prevailing conditions of low unemployment and wage growth in the US, Woolnough said he believes inflation will continue to rise although we will see the effects in two years’ time as interest rates usually take that long to work through an economy.
That period of rising rates will shadow a drop-off in economic growth, which would put the US economy on course for a slowdown in 2019. However, the tax cuts introduced by the US president are likely to extend the period of growth into 2020.
Woolnough has overseen M&G Optimal Income since launch in December 2006 and is joined by deputy manager Stefan Isaacs.
Performance of fund under Woolnough
Source: FE Analytics
Since launch the fund has delivered a 116.87 per cent total return compared with a 57.67 per cent gain for the average fund in the IA Sterling Strategic Bond sector. It has an ongoing charges figure (OCF) of 0.91 per cent.
As well as M&G Optimal Income, Woolnough also co-manages the £3.7bn M&G Corporate Bond and the £3bn M&G Strategic Corporate Bond funds