By Lisa Coleman and Andreas Michalitsianos
Making credit assets work harder to deliver returns in today’s incredibly low yielding environment has been a challenge for institutional investors.
Pensions are increasingly turning to investors who can look across the credit spectrum (from investment grade to high yield to EMD to loans), across geographies and across the capital structure for the best opportunities.
Taking a money lender mind-set, for credit investors it’s about finding worthy companies (i.e. borrowers) and buying their debt at the most attractive prices available to generate strong risk-adjusted returns. In practice, for us that currently means a preference for up-in-quality high yield bonds over more highly levered companies.
For example, based on current and forward looking fundamentals, European high yield more than compensates investors for creditor risk, when we look at prices relative to the expected level of losses (average default rate). In other words, the risk premium for buying high yield bonds issued by certain companies is compelling, particularly in Europe.
Even after a strong rally this year, high yield looks good value relative to large swathes of the government bond market now yielding in negative territory as a function of central bank rate cutting. The ongoing support of the European Central Bank also functions as a strong technical tailwind, supporting prices and selectively bonds issued by investment grade companies also looks interesting, particularly in the banking sector where there has been an on-going deleveraging theme which is also supportive to bond holders.
Indeed, as the ECB further expands into selective corporate bond purchasing, there’s increasingly a place in multi-sector credit portfolios for some lower yielding investment grade credit assets. This is partly because the ECB will be physically buying investment grade bonds and partly because the negative deposit rates they and the Bank of Japan have implemented is causing more investors to reach for yield into the world of investment grade from shorter dated investments.
In fact, The ECB is expected to buy up something like half of the net new non-financial issuance across the European market from June onwards. So although all in yields are low on investment grade credit are lower than traditional high yield bonds, the capital appreciation prospects and risk-adjusted yields still make it a compelling investment over the medium term.
Currently our most meaningful overweight allocations are to sectors where we see the greatest transparency on cash flows. So within high yield credit it might be communications or technology companies providing sufficient yield and spread for the probability of any loss. We strive not to overextend in the riskier credits, even within a high yield allocation. As a result, our portfolio reflects a more defensive tilt with a preference for issuers with a stable cash flow profile, such as healthcare, cable and utility companies.
Squeezing better risk-adjusted returns out of credit is also about considering the role that hedging strategies like derivatives can play. For example, opportunistically buying “insurance” gives managers the ability to capture upside potential while still having protection from losses when the markets are overvalued.
If you look at some of the broad trends impacting debt markets, greater regulation has meant investment banks have reduced their footprints across capital markets. In practise this means they lower corporate bond inventory and less ability to act as a buffer to market volatility. As such, we view the ability to implement strategies intended to dampen the impact of rising volatility via liquid derivatives as a core
Lisa Coleman and Andreas Michalitsianos are fixed income portfolio managers at JP Morgan Asset Management
