Shares in Legal & General Group (LSE: LGEN) have fallen by 21% so far this year, significantly more than the 9% decline recorded by the FTSE 100. It’s been a similar story at Aviva (LSE: AV), which is down 19% so far in 2016.
The underlying cause of the problem seems to be the growing fear of an increase in defaults on corporate debt. Of particular concern are banks and other companies with exposure to China and to the oil and mining sectors.
Companies such as Aviva and Legal & General own large portfolios of such corporate bonds, to fund their annuity businesses.
New information?
To try and address investors’ concerns, Legal & General published details of its bond portfolio this morning. The group revealed 65.8% of the bonds in its annuity bond portfolio are rated A or higher and 96.8% are BBB or higher. BBB is the minimum required for a bond to qualify as investment grade.
Aviva’s bond portfolio looks quite similar. According to the insurer’s last set of accounts, 76% of its portfolio is rated A or above, and 92% carries at least a BBB credit rating.
The investment grade profile of these portfolios should make defaults relatively unlikely. However, the reputation of credit rating agencies took a battering during the financial crisis. Can we trust them this time?
Neil Woodford’s view
It’s almost impossible for private investors to form an independent opinion of these firms’ multi-billion pound bond portfolios. They’re just too large and too complex, and we have too little information about them.
Even top fund managers such as Neil Woodford have to take a lot on trust, but they do have the advantage of being able to question the company’s management directly.
In his January fund update, Mr Woodford said that although Legal & General does own quite a lot of corporate bonds, the group has already made provision for up to £2bn of losses. Mr Woodford also pointed out that Legal & General has a strong focus on credit quality, and didn’t experience any bond defaults during the financial crisis. He expects a similarly robust performance this time.
I’m tempted to agree with Mr Woodford, although I think it’s worth remembering that near-zero interest rates and generous quantitative easing meant that bond default rates across the whole market were unexpectedly low after the financial crisis.
A potential income buy?
Despite this risk, my view is that both Aviva and Legal & General are likely to be good income buys at current levels.
Aviva trades on 8 times 2016 forecast earnings, and offers a prospective yield of 5.7%.
Legal & General still carries a slight valuation premium, on 10 times forecast earnings. However, the recent fall in the group’s share price means that the forecast yield for 2016 has now risen to 7%.
Such a high yield does imply some risk of a dividend cut. However in my view, the long-term income potential of Legal & General’s business may mean that this is a risk worth taking for investors with a three-to-five-year view.