Where to find value in bonds

Bonds are expensive. But as professional investor Kevin Corrigan explains, you can find value by stepping away form the herd.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Kevin Corrigan, head of fundamental fixed income, Lombard Odier Investment Managers.

Things don't look that attractive in the bond world. Government bonds with their low yields offer meagre protection against rising interest rates, which will surely arrive at some point. Investment-grade corporate bonds are still fully priced. Non-investment-grade (high-yield) corporate bonds tend to be volatile and pay little in return for the risk of owning them.

But look closer and, in our view, the structure of the bond market offers a glimmer of hope for anyone prepared to step away from the herd. The distinction between investment-grade (bonds rated BBB and above by ratings agencies such as Moody's) and high-yield (BB and below) is very marked. And the message it gives is oversimplistic: investment grade is "safe"; high yield is "risky".

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Bond investors often focus on one or another. Regulators take note of how much capital banks and insurers set aside in each category.

This means that most investors choose not to cross the line between BBB and BB, leaving value for those of us who are able to focus on this crossover (or "5Bs") zone. From June 2005 to June 2014, bonds in this zone have offered higher (+6.86%) annual returns than pure investment grade (+5.08%).

The maximum loss investors sustained on 5Bs bonds (-16%) is below that of high yield (-24%) and investment grade (-18%). So the risk/return ratio of 5Bs compares favourably.

Opportunity lies in bonds falling from investment grade to high yield ("fallen angels"). These must be sold by investors who are barred from owning high-yield. These forced sellers drive the price down. But the bond then enters the high-yield index, and its price may rise as new, high-yield buyers step in.

So the bonds can be sold when a ratings downgrade is expected, then bought again at lower prices as investment-grade investors are forced to sell, but before high-yield investors look at the new entrants.

Bonds moving the other way up the ratings ladder, from BB to BBB are "rising stars". One example is the bond issued by German tyremaker Continental. The price of this bond rose from 102 to 106 cents soon after it was upgraded to a BBB rating by Moody's. So when the natural buyers return after a bond has settled down in its new home of investment grade or high yield, the underlying value of the bond comes back to the fore, having been partly overlooked in the move.

Research from America shows that investment returns from downgraded bonds (those moving from investment grade to high yield) were negative in the nine months leading up to the downgrade, and when the downgrade actually occurred. Returns remained weak for up toa full three months after the downgrade.

But prices then rallied, and downgraded bonds outperformed, by an average 6.63% in the24 months after the downgrade.If you're looking to take advantage of this crossover zone, you could consider buying bonds in companies that are likely to merge and so strengthen their balance sheets, leading to an upgrade from high yield to investment grade.

As well as merger and acquisition-led opportunities, we believe there are also companies that have recently been upgraded that will form part of the investment-grade universe in due course. Corporate bondsthat have done well after such an upgrade include Continental.

The slow but steady stabilisation in peripheral Europe's borrowing rates is also providing support for companies on the ground, particularly those moving from high yield to investment grade. This in turn provides particular opportunities for investors scouring the BBB-BB space.

Kevin Corrigan is head of fundamental fixed income at Lombard Odier Investment Managers.