By Lisa Coleman
Institutional investors face challenges on multiple fronts in their credit investments. Credit risk levels are on the rise, but reliable sources of income and return remain scarce. In today’s environment, simply moving down the credit curve in order to boost yields and plump spread cushions is ill advised.
Taking the measure of how conditions currently look across the credit space:
European investment grade credit returns were challenging in 2015 due to fairly serious bouts of volatility such as the German bunds shock, concerns over China’s economic growth, the resurgence of the Greek debt crisis, etc. Idiosyncratic stories are also becoming more prevalent. If we consider the range of unanticipated news flow impacting individual names, that’s certainly had an impact. Whether you’re looking at the euro, USD or sterling market, idiosyncratic risk is on the rise.
In general, the fundamental backdrop for European investment grade credit is more favourable than the US, because of a real divergence in leverage trends. US issuers are leveraging their balance sheets in order to fund M&A, do buybacks and pay dividends, taking on larger amounts of debt. Leverage is also rising as a function of the debt relative to earnings (EBITDA), as earnings remain underwhelming due to headwinds from the stronger dollar and the lower oil price. In other words, EBITDA levels are falling as debt piles are ballooning. We saw over $1trn in investment grade issuance last year and if that debt level doesn’t slow in time for earnings to catch up, the fundamental back drop for US industrial issuers will become more concerning.
The average European investment grade company is being much more conservative, keeping their leverage low. If we think of bond investors as effectively money lenders, it’s desirable to lend to an entity that is deleveraging their balance sheet. That’s clearly a current trend across Europe, where investment grade valuations are also relatively low, offering compelling value for the strength of companies we’re able to access. Despite the low yields, on a spread per unit of leverage basis, European investment grade and also European high yield are attractive.
European bank debt also looks interesting, such as Alternative Tier 1 securities and CoCos (contingent convertibles). These look to be good value because European banks face regulatory pressure to increase capital (and hence issue debt) and to reduce businesses with greater risk and consequently higher capital charges. In fact, some AT1s are potential upgrade candidates. Even in the fact of significant market volatility, these areas of the market have remained relatively stable.
Given this nuanced credit outlook, it’s reasonable to assume investors will have to be tactical and selective in order to generate returns; a multi sector credit approach can help manage risk while seeking out tactical investment opportunities. Much like a diversified growth strategy that allocates dynamically between return-seeking assets, an unconstrained approach to managing corporate credit can encapsulate exposure to traditional areas such as investment-grade corporates as well as to high-yield bonds, bank loans and emerging-markets corporate bonds, and utilise derivatives to manage interest rate duration.
Lisa Coleman is head of investment grade credit at JP Morgan Asset Management
Comments