AllianceBernstein: time to buy peripheral corporate bonds?

Jørgen Kjærsgaard (pictured), AllianceBernstein’s European fixed income portfolio manager, asks: is it safe to go back into the corporate bond market?

Amid growing confidence in euro area authorities’ response to the regional debt crisis, yield hungry investors have been returning to the riskier categories of corporate debt, including the peripherals: Portugal, Italy, Ireland, Greece and Spain.

Investors are stuck between the need for yield and the fear of “tail risk”-the risk of outsized losses triggered by a market shock. The challenge is to find assets that generate yield, but that are not going to suffer heavy losses in a bad news scenario.

In the peripheral countries, we’d be wary of being overweight in government bonds, which are still overshadowed by debt problems. The same goes for financial sector corporate bonds, which are closely linked to sovereigns. But among the nonfinancial corporates, we think that the balance of upside and downside is looking quite attractive.

We looked at nonfinancial corporates in the peripheral countries, making a simple calculation to give a rough idea of the 12 month excess return in different market scenarios.

At the end of September, peripheral corporates (both investment grade and high yield), were trading at an average spread of about 400 basis points (4%) over Bunds-well above historical average.

If bond prices just moved sideways, the expected excess return over governments would be about 4.8% for the year-quite attractive under current market conditions. .And if spreads reverted to their historical average, the excess return would be a very attractive 8.7%.

In a bad news scenario, if spreads went all the way back to their 2011 highs, the expected excess return would still be positive, at about 1.8%. As shown in the chart, it would take a much worse market selloff to wipe out all excess returns.

ab-chart-1-nov-6

For investors looking for yield, another choice would be euro high-yield corporates, excluding the peripheral countries. We did the same exercise, (see second chart).

chart-2-ab-nov-6

At the end of September, the average spread over Bunds was about 5.8%-slightly below historical average. If prices moved sideways, the excess return over governments would be about 6.5% a year. Both of these are higher than the return on the peripherals.

But the downside scenarios look different. If high-yield spreads reverted to their historical average, the excess return would be a more modest 2.8%. A 270 basis point widening-which would have been the zero-excess-return point for the peripherals- would result in losses of about 4.4%.At the extremes, if spreads returned halfway to their 2008 peak, investors would suffer a loss of around 22%, while a 1000bp move would result in a loss of as much as 42%.

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