However, there are some issues on the valuation side, particularly in sectors where the line is being crossed in terms of what is good for credit versus what is good for equities. Areas such as energy and communications are examples of sectors doing more to benefit shareholders at the expense of bondholders. These are actions such as heavily debt-funded M&A, increased levels of growth capital expenditure, as well as special dividends.
Across both investment grade and high yield in the US, the most important aspect at the moment is to manage interest rate risk appropriately – given the potential effects of Federal Reserve tapering.
Many people suggest the best way to mitigate interest rate risk is by either moving into short duration, or by moving lower down the credit risk spectrum. This can be too narrow an approach. In an already illiquid market, it compounds the issue of crowded trades and concentration of positions. Credit curves are near decade steepness and the pick-up in spread to go from BB to CCC is at pre-crisis lows. This is not the time to go with the herd.
Europe, particularly in southern areas, is the opposite of the US in some ways, with corporates still behaving with bondholders in mind.Instead, investors can take on ‘up in quality’ trades – favouring BBs in high yield versus the lower end – while also favouring the long end of the credit curve versus the short end.
This positioning is against the growing market consensus. It obviously leaves you with the potential for more interest rate risk, because this part of the market is more exposed. This can be mitigated by either buying the bond and hedging with futures – or sell CDS instead of buying a bond, which incurs no interest rate risk.
Europe, particularly in southern areas, is the opposite of the US in some ways, with corporates still behaving with bondholders in mind. Instead of focusing on near-term share price aspects such as M&A, corporates are trying to retrench balance sheets, term out debt maturity profiles and prioritise credit ratings.
However, much of this is now priced in given the outperformance of Europe versus the US over the past 18 months. Many of the strong fundamental reasons to favour Europe are already displayed in the price.
There are still pockets of good value, such as recent German issuer Lowen. The company benefits from low leverage, good free cash flow generation and consistently high margins. In addition, the recent deal was structured to ensure bondholders are attractively compensated should the company perform, avoiding a lot of the shareholder friendly ‘leakage’ that has become prevalent in other areas of the high yield market.
There is value on the cusps of emerging markets, particularly in higher quality countries and corporates. These are global business operations, with large capital structures. As many of these companies are exporters, they are benefiting from emerging market currency weakness.
US
The biggest effect on fixed income markets has come with Federal Reserve tapering initiated in December 2013. The bid yield on 10 year US treasuries has improved from 2.06 per cent on March 11 2013 to 2.77 per cent a year later.
IRELAND
In January, Moody’s upgraded Ireland’s sovereign debt rating to Baa3 from Ba1 and its outlook to positive. On March 13 the National Treasury Management Agency had its first 10-year government bond auction since 2010.
JAPAN
The Bank of Japan is maintaining its strategy of monetary easing, including the purchase of Japanese government bonds at an annual pace of roughly 50trn yen. It aims to achieve a price stability target of 2 per cent.
PORTUGAL
Portugal has seen one of the largest compressions in its 10-year government bid yields, dropping from 6.05 per cent in March 2013 to 4.4 per cent a year later. Ratings agencies have put the outlook for the country as positive.
UK
The Bank of England says falling unemployment is unlikely to push it into raising interest rates before it is ready. The bid yield on 10-year UK gilts has risen from 2.03 per cent in March 2013 to 2.78 per cent a year later.
CHINA
In March, Chaori Solar Energy, a 1bn Yuan Chinese corporate bond defaulted. But the BofA Merrill Lynch Global Research team suggests “a systemic crisis requires a string of low-probability bad outcomes.”
Fraser Lundie is co-head of Hermes Credit
