IPE Institutional Investment: What is your general outlook for fixed income markets, will rates stay that low over the next years?
Woolnough: Even though I don’t believe that inflation or interest rates are going to rise soon, I’m negative on government bonds because of the huge supply of government bonds that we will see over the next few years. A more bullish case can be made for investment grade corporate bonds, where despite a strong rally this year, credit spreads are still very high by historical standards.

IPE Institutional Investment: Corporate Bonds are still “pick of the year” for many institutionals. How long will the party last?
Woolnough: Although we still believe that corporate bonds offer very good value opportunities, and should outperform government bonds and cash over the next one to two years, it is important for investors to realise that corporate bond spreads are no longer pricing in a Great Depression, but ‘merely’ a bad recession.

IPE Institutional Investment: Let us talk a bit more about the scenario for the economy that is currently priced in the bond spreads...
Woolnough: As a result of the strong corporate bond rally, spreads have tightened significantly since the beginning of 2009, such that, on 14 July, US BBB spreads were down to 430 bps. From the start of the credit crunch in 2007 spreads drifted wider, spiking in 2008 after Lehmans defaulted. At that time, some US BBB bonds were yielding around 800 basis points over government bonds – wider than during the Great Depression. We believe that inflows into high yield are likely to continue to support the market and could even lead to further price gains. Although we are still getting paid for the risk, our view, however, is that high yield is now fair value. From a risk/return perspective, high yield is definitely not a low risk investment opportunity. The default rate in high yield is edging up – we estimate that over the next year defaults will reach about 15%. Also, we believe that if there is a setback in equities, high yield is likely to fall back too.


IPE Institutional Investment: Do you think we will see a major correction in the corporate bond markets when defaults start to rise?
Woolnough: The corporate bond market is already pricing in very large number of defaults – in the European investment grade corporate bond market, the extra yield on corporate bonds implies that about 20% of bonds rated investment grade today will default in the next five years. For the high yield market, the implied default rate is about 60% for the next five years. So a rising default rate shouldn’t have a big impact on the market since it is already being priced in. A major correction is more likely to happen if another large systemically important financial institution fails, but this risk has certainly fallen in the past few months.

IPE Institutional Investment: Could you briefly describe the title selection by M&G for corporates?
Woolnough: Credit selection is through a combination of top-down and bottom-up strategies. Our top-down approach means that our fixed interest fund managers form a macroeconomic overview, incorporating views on economic growth, inflation and the yield curve. They look at market expectations and compare it with the economic health of regions, sectors and individual stocks. The investment process proceeds when they find there is a mismatch between economic indicators, bond prices and events in reality. The next stage is to choose the asset classes that offer the best value, whether this means investing in government bonds, investment grade bonds or high yield. Thereafter the fund managers will seek the input of the credit analysts when they make their decisions as to sector and individual credit selection. Currently there are over 120 investment professionals, including 60 credit analysts at M&G - one of the biggest fixed income teams in Europe.

IPE Institutional Investment: Which sectors/industries and which credit ratings do you prefer?
Woolnough: At the moment we favour investment grade issues, specifically BBB rated bonds. This rating category contains large, stable companies whose bonds offer very attractive yields compared with cash and government bonds. We’re still quite bearish on the global economy so we prefer the more defensive sectors such as telecoms and utilities.

IPE Institutional Investment: Is duration currently a value add?
Woolnough: With interest rates now very low, we believe the biggest driver of corporate bond returns will now come from credit risk, rather than duration positioning. We’re generally short duration across our corporate bond funds, though, because we’re negative on government bonds.

IPE Institutional Investment: Many thanks for your insights.