Useful measures to judge credit markets

The question of where the best fixed income opportunities lie is unlikely to raise any laughter, but the issue of perspective is central. It depends on your standpoint – is your objective to reduce volatility or to maximise returns? It also depends on the criteria you use to judge credit.

Let us assume that your objectives are absolute returns at a reasonably attractive level of around 4-5 per cent a year – a target that should satisfy the needs of a broad investor audience in this current yield environment. In this instance, the three useful measures by which to judge credit markets are:

lFundamentals: These are wider external issues that affect the overall operating performance and outlook for companies, whether at a national, sector or individual level. For example, you would examine issues such as the general health of the economy, unemployment, inflation, interest rates, central bank policy, defaults and currency impact.

lTechnicals: The key focus here is money flows going in and out of credit. The fundamentals tend to dominate long-term thinking about where markets can go, but fund flows in the interim can be very powerful.

lValuations: Put simply, how do current risk premiums compare with their historic norms?

The best fundamentals are still in the US judging by these criteria. Investors are seeing growth in GDP, housing market statistics have been strong and the unemployment situation has improved. With the US Federal Reserve poised to normalise its short-term interest rate, it is clear the economy has recovered from the great recession.

Flows into US credit markets have been positive – though there have been short-term bouts of nervous outflows – and valuations look slightly rich. But investors should not be overly concerned given the positive economic outlook. The return potential is better in the US than in Europe, but volatility is higher because of uncertainty about the interest rate rise and the health of the energy sector – a significant factor of US industrial credit.

Fundamentals in Europe, while not strong, are getting better and a resolution to the Greek situation should support this view. Flows have been positive this year. Of course, this means valuations are not as attractive as they were, though some parts of the market retain their appeal – for instance, European investment-grade spreads look appealing.

The yields generally may not be as attractive in Europe as they are in the US, but the European market would appear to offer the prospect of lower volatility as the interest rate outlook is more benign.

Emerging markets have been the best-performing part of the global credit markets this year, rebounding from a poor 2014. They have decoupled from developed markets where fears of interest rate rises dominate thinking.

It means that in terms of valuation, emerging markets may now appear somewhat overvalued.

Fundamentals are always a concern. The stronger dollar and weaker commodity prices, along with geopolitical considerations in some specific countries, make this the least attractive area, but it is where good bottom-up selection can add significant value.

Emerging markets have a very broad geographical sweep. There are some strong economies within the sector and some secure mega-cap businesses that are paying higher yields than they might if they were based in Europe or the US.

The concern for most fixed income investors is the impact of rising interest rates. Though fund flows have generally been positive in the US, Europe and emerging markets so far this year, there is concern about what will happen when rates start moving towards historic norms.

You cannot fight the tape if flows turn particularly negative, but certain parts of the market can offer a degree of comfort if liquidity is a concern. The US is probably the most liquid market of all, and investment grade tends to be more liquid than high yield. Short duration can substantially reduce interest rate risk, and liquidity at around two years’ duration should remain reasonably strong.

What this illustrates is that in the absence of any particular part of the credit market screaming ‘buy’, investors need a more strategic, nuanced approach.

Arguably, a balanced credit portfolio will be tilted towards the US and shorter durations, but the lower volatility of European and certain emerging market high-yield bonds – coupled with US- and Europe-hedged investment-grade bonds – may be attractive.

Michael McEachern is a fund manager at Muzinich