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.
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