Credit markets face challenges but there are opportunities for schemes finds Lynn Strongin Dodds
While the death knell is being rung for the 30-year bull bond market, the credit markets are still alive and kicking. However, selectivity is the key as political risk circles overhead and the Federal Reserve is set for multiple interest rate hikes while the European Central Bank (ECB) is poised to slowly wind down quantitative easing.
"We are definitely coming to an end and the idea that a rising tide lifts all boats is over," says Mirabaud Asset Management fixed income portfolio manager Fatima Luis. "However, we continue to see strong demand from institutional investors because credit is still attractive as a return seeking and liability matching part of the portfolio. The difference today is that the focus has switched to income versus capital appreciation because the returns are unlikely to be as high as last year."
JP Morgan Asset Management investment grade portfolio manager Andreas Michalitsianos also agrees that valuations look high against the historic average but notes it is still a reasonably attractive asset class given the upturn in economic data.
In fact, despite the image of a stagnant, sluggish region, the eurozone surprised the pundits by ratcheting up 14 consecutive quarters of growth while the unemployment rate has returned to single digits. It also outpaced the US last year, for the first time since the financial crisis broke in 2008, with a 1.7% increase compared to the 1.6% registered across the Atlantic.
Equally as important, sentiment has improved with the final Markit Eurozone PMI Composite Output Index — which measures managers' confidence — being firmly in positive territory, at 54.4, the 43rd straight month in which it has signalled optimism about the eurozone. In fact the prospects are encouraging enough for the ECB to consider tapering its monthly buying programme next year, which it already trimmed from €80bn (£69.6bn) to €60bn last year.
Despite the optimism, headwinds are also blowing with the French and Germans heading to the polls throughout the year. The possibility of populist governments rearing their head as they have in the US and UK will rattle markets, especially if far right candidate Marine Le Pen wins the second round in France. Given last year's surprise results, it is hard to predict the outcome but the French bond market has seen yields widen and narrow depending on the latest poll.
A recent report by Moody's Investor Services though shows it is unlikely that any of these populist parties will gain sufficient electoral support to seek a mandate for exit from the euro area in the near future. However, they will still have the ability to wreak havoc and influence the political agendas. Moreover, progress may be hampered if complex, fragmented and complicated coalitions are created as a result.
As for the UK, there is no doubt that the Brexit negotiations will overshadow financial markets even though the country has bucked expectations and recorded strong GDP growth of 1.8% in 2016 after the June referendum.
Next year is also expected to be relatively buoyant at 1.4%, which was raised from analysts' forecasts of 1.1% reported last December. The outlook farther down the line though is not as bright, with estimates for 2018 being cut from 1.4% to 1.3% as consumer confidence is slipping and wage growth softening.
It is no wonder then that against this backdrop, fund managers are treading carefully. "What credit markets hate is a recession," says Michalitsianos. "The further away from this type of scenario the better but today the key is diversification because there is also a degree of uncertainty with the Brexit negotiations and the European elections. This would be a catalyst for the dispersions, which currently are low, to increase. There is not a lot of difference at the moment and spreads are tight between risky assets. The strategy we are pursuing is to pick the winners and avoid the losers, which means those companies with negative cash flows."
One sweet spot is loans which are below investment grade. Secured loans sit below investment grade level but are based on the robustness of companies' operating business and come with a floating rate note component, which provides a hedge against interest rate rises, according to Michalitsianos.
Opportunities across sectors
Karen Watkin, portfolio manager for the Multi-Asset Solutions business at Alliance Bernstein, also believes in an active approach and sees opportunities in different segments. For example, for pension funds looking to generate growth the best bets in the investment grade space are in Europe although globally the sector looks relatively unattractive given today's low yields. She prefers emerging markets from a valuation point of view while global high yield offers attractive yield compared to global investment grade, 6.14% compared to 2.79%, though being discerning is critical in both markets.
Watkin adds that "given the dispersion in monetary policy and ability to identify clear winners and losers from impact of the new US administration, it is important to be selective across countries and sectors. For example, in emerging markets, it is important to look at countries that might be affected by Trump's protectionist policies. We like Brazil because the political and economic reforms are having a positive effect and the country is moving out of recession."
Emerging market debt and high yield debt are also on the list for Hermes Investment Management co-head of credit Fraser Lundie. "We like Latin America, particularly Brazil, Chile and Mexico, at the corporate level mainly because several global companies are either based or have partners in these countries. As for EM sectors, we like investment grade metals and mining because they are relatively cheap, companies have strong balance sheets and it has performed well. We are careful in other sectors such as auto parts where we see significant issues, for example in Mexico due to tax and protectionist policies."
Lundie is also a proponent of high yield bonds, "because they are an extremely resilient asset class and can withstand market volatility. From a long-term perspective, high yield very rarely loses money on a rolling three-year basis. Today, balance sheets look extremely strong and companies have been pre-emptive in their refinancing of securities. I think it is difficult to see an uptick in default rates given low oil prices and the absence of any shocks."
This is particularly true in Europe, where Moody's is predicting a steady speculative-grade corporate default rate of around 2-3% supported by strong fundamentals and moderate refinancings. The US is also expected to report a drop to 3.5% in January 2017 from 5.8% last January, although the ratings agency does acknowledge the possibility of isolated defaults of companies vulnerable to event risk.
While many fund managers are focusing on high yield and emerging market debt, others believe that investment grade, albeit not the most exciting, still has a role to play. "Pension funds are long-term investors and the benefit of investment grade is that they offer a bit of carry on top of government yields," says Lionel Pernias, head of buy and maintain credit strategies at AXA Investment Management. "This is a defensive strategy that helps mitigate the downside risk, which is important in this environment because of the structural market changes and limited liquidity. The best approach is to have a global opportunity set to diversify the risk and maximise the capture of the spread."
Cheyne Capital head of credit research Duncan Sankey also believes the risk reward trade-off is better in investment grade than high yield credit. However, he advises looking at the credit default swap (CDS) market as an efficient way to gain exposure and harvest the value.
"The volume of the ECB bond buying programme has reduced the spread on European corporate over government bonds but it has not pushed down CDS spreads as much," he adds. "Also, CDS' are standardised, fungible contracts that do not atomise liquidity across a range of structurally distinct issues and can be cheaper to own. For example, take French energy company EDF: it is approximately 60bps cheaper to own its credit risk through five-year CDS than through a bond of similar maturity, plus there is no rate risk."
Although many institutions are focusing on a particular asset class or strategy, others with limited resources are opting for a multi-asset credit (MAC) fund, while those with deeper pockets and long term horizons are venturing into direct lending. The benefits of a MAC is that investors can reap real returns of 2% to 3%, with a reliable income flow and relatively low volatility, according to BlueBay Asset Management head of credit strategy David Riley.
"We also believe there are structural opportunities in direct lending because of the banks stepping away due to regulations," he says. "Pension funds who are able to lock up capital for four to five years can take advantage of the illiquidity premium and capture overall returns of 300 to 400 basis points over multi-asset credit funds."
M&G director, global institutional distribution, Annabel Gillard echoes these sentiments and points to lending to small to medium sized enterprises as an area that continues to generate strong risk-adjusted returns and cash flows.
However, she notes there are challenges and a different skillset is needed when structuring these deals. "You need to ensure that the covenants in place are at the right level where there is protection but that there's enough flexibility for the company to thrive, even in difficult markets," she says. "It also requires close monitoring and in-depth credit research and analysis."
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