Credit markets have witnessed an almost unchecked rally for the past nine months, only rivalled by the recovery in 2009 following the correction caused by the 2008 crisis.
We would suggest that some corporate bond spreads, particularly within high yield markets, are reaching levels which are at best fully valued, and more worrying, could represent lows in the current cycle.
While there is a level of optimism that warrants tight credit spreads, there are also clouds on the horizon in terms of a weakening macro environment.
The massive injection of liquidity into the financial system has barely registered an upturn in economies. However, it has distorted asset valuations from the underlying fundamentals and it is this fact that could prompt some cautionary positioning from investors in fixed income markets and selective investment in equities.
An index level observation that brings this home is the relationship between iTraxx Main compared to iTraxx Crossover credit default swap (CDS) indices. The iTraxx Main consists of 125 equally weighted European investment grade credit default swap CDS credit spreads, while the iTraxx Crossover consists of 40 of the most liquid sub-investment grade CDS credit spreads.
During times of ‘risk-on’, the ratio between these two indices falls, whereas during periods where risk markets fall, the ratio rises. At present the ratio is approaching long-term lows.
At a fund level, we have taken steps to reduce outright beta risk both in government interest rates and also credit.
This has been achieved by taking profits in lower credit-rated instruments and also by reducing interest rate duration by the sale of highly liquid government bond futures.
There have been many commentators suggesting that the great bull-run in bonds, both credit and government, is over and a rotation into equities is gathering pace.
Certainly inflows into some of the larger corporate bond funds have slowed, however, the allure of holding a debt instrument, rather than equity, should not be underestimated within a diversified portfolio. A bond can be split into constituent parts, each representing potential profit (or loss).
While as a whole, the overall ‘package’ may not represent good value, measures can be taken to isolate aspects of the bond that do offer profit making potential. A case in point is with our holding in Qatar 3.125% 2017, a dollar denominated bond.
At the start of the year this bond was purchased and a corresponding amount of US government bond futures sold against the position, reducing the interest rate exposure to zero.
With this bond now priced at $106, the return in the period has been 0.85 per cent, the equivalent US Treasury bond has fallen 0.4 per cent, providing a total return in excess of 1.25 per cent.
Graham Glass is head of fixed income at City Financial
