Lower valuations and diminished extension risk, which followed a significant sell-off last summer, have created more opportunities after successive years of soaring valuations.
But the normalisation of US monetary policy after six years of stimulus has intensified duration, convexity and volatility risk across swathes of the global credit market.
In addition to these traditional fixed-income risks, secondary market illiquidity – a situation fuelled by regulatory restrictions on the amount of credit inventory that can be held by banks – has not eased. In a major correction, this will test portfolios that have grown on the abundant inflows and issuance since the financial crisis.
Default rates should remain below long-term averages for the foreseeable future as liability-term structures continue to provide issuers with long time spans until their first significant maturities are due.
With low default rates largely priced into valuations, security selection is equally important as is company selection in generating outperformance. Picking the right securities within the capital structures of issuers is a suitable approach as we begin 2015.
Considering the idiosyncratic risks of firms, in conjunction with the outlook for the region and sector in which they operate, will be vital. The US resources sector is a case in point.
The collapse of the oil price is weighing heavily on oil, gas and infrastructure firms participating in the shale boom – particularly those that built their businesses on assumptions the price of crude would consistently be greater than $60 per barrel.
Resources companies comprised roughly 5 per cent of the US high-yield market when Lehman Brothers collapsed. The boom in unconventional oil and gas production has driven this by a fourfold rise to 20 per cent, meaning that a lot of the leveraged debt contributing to the growth of the sector was focused on the energy boom. Not all of it was issued by firms assuming oil would continue to trade at a higher price than it is today.
There are many high-quality operators that are showing resilience. Typically, they are low-cost producers with substantial existing and untapped reserves, operating a sustainable drilling programme that is supported by price hedging around annual production targets.
Many such businesses have already completed capex programmes and do not carry heavy debt burdens under current conditions. And they provide greater security to creditors if they own a balance of oil and gas deposits.
With US demand for imported oil now easing due to rising domestic production, plus ongoing price competition among oil exporters, the oil price could stay depressed and may lead to a contraction of the US resources high-yield sector. If this happens, the survivors are likely to thrive with fewer competitors.
As ever, investors must assess the risks and prospects of each issuer. In their analysis of US oil and gas companies, they should focus on the quality of their deposits, businesses and management before considering the relative value of the debt instruments in their capital structures.
Investors should also keep watch for heightened idiosyncratic risks among newer entrants to the corporate debt market. The common thread linking many of the European high-yield blow ups in 2014 was that these firms entered the debt capital markets in the past three years. They issued debt on the assumption that business growth would enable repayment – clearly, this assumption is now being questioned.
Combined, these dynamics mean that selectivity – paying the right price for the right securities – will be crucial to outperforming in 2015.
Mitch Reznick is co-head of credit and head of credit research at Hermes Investment Management
Fixed income: in numbers
£139m
Total net retail sales into Investment Association-listed fixed income funds in October 2014
15.2%
Percentage of Investment Association total assets held in fixed income vehicles as of October 2014
£162.9m
Net retail sales of the best-selling bond sector – sterling corporate bonds – in October 2014
