In the 10 years since the collapse of Lehman Brothers – often billed as the defining moment of the global financial crisis – the landscape for bonds has changed significantly. We are now in a world where quantitative tightening is firmly in place following years of easing, and interest rates are finally on the up in the US and UK.
While we remain confident in the medium to long-term outlook for credit, the asset class is increasingly vulnerable to negative sentiment and technical factors on a shorter timeframe.
A number of dynamics are causing volatility to rise and could hit credit markets over the coming months to varying degrees. We believe it is possible to make money in this environment – particularly if you can use the various tools available in a flexible mandate – but it is important to understand exactly how these changing conditions could potentially affect fixed income markets.
On the macroeconomic front, opacity around Brexit, and how Britain will look in its aftermath, still lingers a full two years after the historic vote and it is still impossible to say how soft or hard the eventual exit will be. We remain in the camp that believes there will ultimately be an agreement, but the chances of a no deal have risen and that scenario would lead to gilt yields rallying and sterling weakness.
Elsewhere, growing fears over protectionist policies and potential trade wars pitting the US against China, Europe or possibly both could clearly have a negative impact for global GDP – although again, consensus suggests that for all the rhetoric, President Donald Trump and peers around the world will ultimately stop short of doing anything that causes permanent damage.
Europe has also given markets plenty to fret over in recent months: while the European Central Bank has done a great job in steadying markets, uncertainty surrounds how the credit markets will react to potential road bumps when there is no ECB buying of corporate bonds.
Higher premiums are already having a short-term impact on secondary spreads, seeing them widen. Investor appetite remains strong, but given these increasing premiums, many [investors] are currently focusing on primary deals to get cash into the market.
Key points
- Bonds are vulnerable to negative sentiment
- Geopolitical tension contributes to volatility
- Returns will be more 'carry driven'
Negative sentiment
Looking at the supply side, aggregate levels of euro credit are higher than in previous years and, given the increased volatility, issuance is more focused on shorter funding windows.
Sterling-denominated bond supply has remained fairly steady, while the US market is less active than in 2017, although there is a risk of a fresh spate of issuance as a result of merger and acquisition activity.
Meanwhile, recent events in Italy and Turkey have also concerned bondholders: so far, events in Turkey – the country’s disagreement with the US has sent its currency into freefall – have had limited impact on credit but if the political situation in Italy heads south, it could potentially have a greater contagion effect on the rest of the Europe.
Overall, this increased geopolitical tension will likely continue to undermine spreads and add to volatility. Corporates aiming to find funding in capital markets look for stable conditions as they generally have to pay lower new-issue premiums. In periods of higher volatility, as stated, these premiums trend higher in order to compensate investors for the increased risk, which is negative for existing bonds as spreads drift wider to the new clearing level.
We prefer to see this as an opportunity rather than a threat, however, and while investors should be cognisant of such short-term risks, we believe fundamentals broadly continue to support credit.
Global default rates remain low and underlying economic growth is still positive and although the period of extraordinarily accommodative monetary policy is nearing its end, with the Federal Reserve hiking interest rates and the ECB the latest to join the tapering party, the unwinding will be slow and considered.
Corporate leverage in the UK and eurozone remains at conservative levels and, while it is higher in the US, this reflects shareholder-friendly policies (share buybacks, special dividends and increased levels of M&A) and the fact the country is at a more advanced stage in the economic cycle.
Valuations
On the valuation front, spreads have widened out significantly from their recent tight levels. Although below long-term averages, they remain supported by loose fiscal and monetary policies and the economic backdrop.
Credit curves have steepened, offering value at the longer end while euro and sterling bonds have underperformed the US year to date, with the former pricing in the negatives outlined above.
Taking all this into account, we remain positive on the asset class although returns will be more “carry driven” – meaning the income earned from the bond is outweighing the drop in its price – than they have been in recent years.
We see selective opportunities for spread compression and so we are seeking longer duration – that is, more sensitive to rises in interest rates – plays in our favoured sectors, including insurance and telecoms.
We are happy to move down the credit curve for additional yield pickup, with the flexibility of our mandate allowing us to sell interest rate futures, which offsets the duration of the longer-dated bonds, thereby reducing interest rate sensitivity.
Overall, the reduced levelof spread correlation (a function of central banks reducing asset purchases) should create relative value opportunities within sectors and, coupled with cross-market opportunities, this supports our view that credit will continue to deliver attractive income returns.
Within this context, our favoured markets remain the UK and US over Europe and we continue to prefer investment grade over high yield. We reiterate, however, that flexible mandates can help generate returns while reducing volatility against more challenging backdrops.
Kenny Watson is co-manager of the Liontrust Monthly Income Bond fund
