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Today's investors have a number of new options for investing in corporate bonds. Favourable conditions on the capital markets have substantially increased the number of products available from borrowers with lower credit quality over the past two years. Derivative and other alternative investment instruments have further broadened the product range for investors. The increasing complexity of product innovations, however, has made it difficult to choose the optimal investment strategy. Private investors would benefit, therefore, from analyzing the effects of new financial instruments and structural changes.
A study of corporate bonds conducted by UBS Wealth Management Research analyzes the structural trends and product innovations in the market for corporate bonds and their consequences for the portfolios of private investors. The study is made up of two parts. The first part gives background information and an overview of the players in the corporate bonds market. The second part analyzes the impact of newer investment options in corporate bonds as regards yield optimization.
The market for corporate bonds is one of the key areas in the global financial market. With a volume of USD 4.3 trillion, the corporate bond trade is just as large and important as the US equity market: the value of stocks listed on the Dow Jones Index is about USD 3.6 trillion. The USD bond market is the largest and most liquid in the world. However, the introduction of the euro has gradually led the market for corporate bonds in Europe to become more important and more liquid. The proportion of outstanding bonds ranked in the highest rating class by the rating agencies is growing ever smaller. Although the financing requirements of companies outside of the financial sector has risen, issuers in the financial sector account for the largest share of new issues - and this share is increasing.
Changes in the market and the reasons behind them are having an effect on the optimal portfolio structure. The study attempts to provide answers to some of the most important questions in bond portfolio management. Many private investors have concentrated their assets in just a handful of bonds with a very high rating. In doing so, they are foregoing higher interest rates. The portfolio's yield can be increased without added risk by means of efficient diversification.
Most sectors of the economy are cyclical. The yield premium on corporate bonds, which serves as compensation for the risk of payment default, is likewise cyclical. The strength of economic growth and the health of corporate balance sheets are decisive factors influencing the upward or downward movement of yields. This relationship can be used to create an investment strategy that anticipates credit risk.
Over the past few years, numerous derivative instruments and alternative investment instruments have been created in connection with corporate lending. These instruments can be used as a practical means of achieving credit risk diversification and positioning with respect to the credit cycle. These products were first used by institutional investors to manage their corporate credit risk via a transfer to capital markets. More and more credit derivates and structured products are becoming available to meet the needs of private investors. Credit derivates are being used more frequently in the fund sector, creating new and attractive investment strategies. We present some innovative products that use credit derivatives in various ways making it considerably easier to create diversified credit exposure.
The creation of new financial instruments and the clear weaknesses of existing institutional regulations entails the introduction of new regulations. The recent Basel Capital Accord is a package of guidelines intended to improve the stability of the financial system. The impending introduction of the provisions will likely have a significant effect on the incentive of banks to securitize loans. This may also affect the volume of new issues of asset backed securities (ABS) and other securitized credit products. This is therefore also relevant for private investors because the vast majority of ABS today belong to the highest rating class.
The broader investment range and changing conditions are increasingly affecting investment decisions. Only well-informed private investors will be able to achieve above-average yields. The interviews conducted in this publication with Wolfgang Reichenberger, CFO of Nestlé SA, John Fraser, UBS Global Asset Management, Gerry Rawcliffe, Fitch Ratings, Stephen Kealhofer, DCI and Scott McDonald, Mercer Oliver Wyman aim to provide information that is relevant for private investors.