Unconstrained credit is not new but investors are seeing the potential for searching the globe for a diverse array of credit risk, ultimately allowing for higher risk-adjusted returns. Lynn Strongin Dodds takes a closer look at the sector.
“You have to be selective in US high yield because we are going to see more companies file for bankruptcy under Chapter 11.”
Joseph Mayo
Adopting an unconstrained approach to credit is not a new theme but one that has gained momentum over the past year. A combination of sluggish yields, the ever present threat of a US rate hike and China’s economic slowdown has cast a long shadow over the bond markets. As a result, institutions are searching for the best ideas across the yield curve and regional borders.
Unlike past turbulent times though, there are no favourite stomping grounds.
As Sandra Crowl, member of the investment committee at Carmignac notes: “Over the last 10 years the developed market credit asset class has been the stalwart for nonbenchmarked fixed income funds that have been able to surf the deleveraging wave that started in the US at the end of 2008. After rolling down the US rating curve as valuations became rich in A-AAA-rated bonds, opportunities were then rife in the European corporate credit market as deleveraging among corporates was necessary in the financial and sovereign crisis.”
Fast forward to today and the hunt for yield in a depressed rate environment has created market distortions where some credit sectors are priced too low for the risk taken, according to Crowl. She points out that investment grade spreads have moved from 180 mid-2012 to below 50 in March this year following the onset of the European Central Bank’s latest round of quantitative easing. Since the summer and following on from the contagion of the US energy market selloff, low commodity prices have raised the insolvency risk of commodity producers so raw material sector credit has sold off significantly.
“One of the interesting features of today’s market is the unwillingness to accept bad news and this has translated into an inability to allocate assets,” says Richard Ryan, fixed income fund manager at M&G Investments. “When bad news hits valuations fall or positions are sold off until there is more clarity. This does not happen when markets are robust and there is a high degree of risk taking. People are able to rationally look through the negative news.”
PRIME TIME FOR PICKING
Instead of being overly anxious Ryan along with other fund managers believes this is prime time to identify reasonably priced individual opportunities. By applying a bottom- up approach to credit, akin to equity stock picking, Ryan sees pockets of value in out of favour sectors such as metals and mining with spreads that are in some cases wider than those in 2011 when Europe was suffering from its sovereign crisis.
“The bad news is already built in and you do not have to take heroic bets. In general, it is about doing the analysis, kicking the tyres, and asking questions such as what am I being paid for?”
Mark Cernicky, managing director, global fixed income at Principal Global Investors, is also looking at independent energy as well as midstream companies that are involved in shipping and storing the oil, because they are much less sensitive to the vagaries of the oil prices.
“Other areas we are focusing on are shareholder friendly companies such as pharmaceuticals and financials that are de-risking,” he says.
Overall, fund managers are treading cautiously in the investment grade space due to the supply overhang. Both Europe and the US have been hit by a deluge which has knocked investment performance and led to a higher risk premium or extra yield between riskier corporate and the safe haven government bonds. In September alone, Thomson Reuters figures showed investment grade issuance in the US hit $60bn (£39bn) with companies in Europe selling around €60bn (£43bn).
The trend is likely to continue until the Federal Reserve takes a decision over the direction of rates. While it is inevitable, companies are taking advantage of the dithering and rushing to raise finance cheaply as well as support the spate of mega mergers such as Anheuser-Busch InBev’s purchase of SABMiller. The brewer is expected to set a record for debt issuance by selling bonds worth as much as $55bn to finance its staggering $106bn takeover.
“If you are an ambitious CEO, you will be taking advantage of current low borrowing costs to fund a deal,” says Owen Murfin, portfolio manager on the Blackrock global bond portfolio team. “The InBev/SAB Miller deal will involve a sizeable bond issue and one question is which market will they chose to sell them. I would like to see more diversification from the US but it is not that easy in Europe to get a big deal away. However, there has been high event risk, causing an overabundance of supply especially in the investment grade side.”
HIGH YIELD WOES
Managers are also applying caution in the high yield arena where the US continues to be the main contender albeit its share of the Bank of America Merrill Lynch (BAML) Global High Yield index, which tracks $2.2trn of assets, has been whittled down to 53% from 89% in 1998, according to data from Hermes Investment Management. Europe’s contribution by contrast has risen to 21% from a mere 8%, while the rest of the world accounts for 26% compared to 3% during the same period of time.
US high yield bonds have had a difficult year and have underperformed their European peers mainly because of their strong ties to the energy sector. Roughly a fifth of US high yield debt outstanding has been lent to the oil and gas industry and defaults seem likely as many of these companies borrowed money when oil prices were toppling over $100 a barrel. Now they are struggling with the current $50-60 price range. In addition, the sector also took a greater hit than Europe when the Chinese economy started to splutter.
“You have to be selective in the US high yield universe because we are going to see more companies file for bankruptcy under Chapter 11,” says Joseph Mayo, managing director, head of credit research at Conning. “This will impact the entire market because of its increased retail investor focus, which makes it more prone to undulating swings in performance. But, we see opportunities in fundamentally-sound companies.”
Many managers such as Gregoire Pesques, fund manager at Amundi Asset Management have a bias towards European high yield because it still offers better value and companies are more domestically oriented. For example, three quarters of the 30 largest high yield borrowers that disclose revenues are generated within its borders.
“If you look at the US, the high yield energy index was down 9% and that is a significant part of the main benchmark,” he says.
Others are looking beyond European credit to secured loans for value. Thierry de Vergnes, global head of debt fund management at Lyxor Asset Management, believes these assets are a good diversifier and offer exposure to high yielding debt with a floating rate income profile that ranks at the top of the capital structure of the issuer.
“We see these as the 4-by-4 assets of the fixed income universe,” he adds. “If you think of a bearish scenario, then you are in a better position because they are secured and offer better protection than typical high yield bonds, but if you are bullish then you can expect to get an increased yield as the coupons paid by the loans will benefit from the increase of the euro Libor return.”
STEPPING BACK INTO EMs
Not surprisingly, the industry is also pursuing different strategies in emerging market (EM) credit.
“They have suffered a double whammy – the uncertainty over the Fed’s return to normalisation and the lower growth trajectory of many countries,” says Yves Bareau, chief investment officer, emerging markets debt at JP Morgan Asset Management. “This has resulted in underweight positions and questions over when to re-engage. One of the lessons though of the financial crisis is that at some point you need to step back in.”
Bareau favours US dollar sovereign over local currency debt, largely given the fundamentally weak backdrop for EM foreign exchange and is more cautious over corporates due to the late cycle. In terms of countries, Central Eastern Europe is at the top of the list because of its strong economic fundamentals as well as India, which is enjoying higher growth, lower inflation and a relatively stable currency thanks to Modi’s reforms.
“We are also moving back into Russia because it had a massive sell-off and valuations are attractive,” he adds. “There is a concern over geopolitical risks such as Syria but we think the economy has turned the corner and is over the worst.”
Fraser Lundie, manager of the Hermes Multi-Strategy Credit fund, also notes that larger emerging market companies are in much better shape than 10 years ago and that the gap has narrowed with their developed market peers from an environmental social and governance (ESG) standpoint.
“There is greater transparency and stronger governance,” he says. “For example, today you can readily compare a sector the way the sector looks at itself – take a company such as Mexican-based Cemex with German based HeidelbergCement – two global cement competitors that can now be analysed as the peers that they are; breaking down the EM/DM silos.”
Their hard won efforts, perhaps, explains the furore created by the investment community in the summer when BAML threatened to exclude EM issuers in its broader global high yield index.
“By embracing corporates from across the globe, investors can access risk from a diverse array of locations and credit qualities – allowing for higher risk-adjusted returns,” says Lundie.
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