At ING IM, we have a neutral stance on spread products in our tactical asset allocation (TAA). High yield credits are our fixed income favourite and one of our arguments is that these bonds are able to generate positive returns in an environment of rising government bond yields, as we have seen in the past. We’re also conscious that most of the recent spread widening has been reversed and thus, we’ve have become more positive – or less negative – about credit markets.
After everybody started to talk about tapering, volatility in fixed income markets rose substantially and credit spreads widened and frightened investors withdrew money from bond markets and reduced the risk in their fixed income portfolio.
About a month later, after several reassuring statements of central banks and growing evidence of a recovery in the developed economies, volatility started to ease and markets entered calmer waters. Currently, most of this spread widening has been returned to normal despite the fact that the 10-year US Treasury yield has not declined materially and remains around the levels that were reached early July. We’re also aware that the higher Treasury yields, the lower the credit spreads, which is historically the norm.
This makes perfect sense, as higher treasury yields are often a reflection of better economic data. A growing economy does, after all, have a positive impact on corporate health and corporate bonds should therefore benefit from stronger balance sheets and a lower default risk as balance sheet quality improves. This is a good illustration of the equity characteristics of an investment in (high yield) corporate bonds. In our view this is also the case today. Economic data in developed markets are improving and earnings growth has bottomed. Eventually, good economic news means lower credit spreads and outperformance relative to government bonds.
The negative correlation between credit spreads and treasury yields implies that the net impact of a rise in treasury yields on the return of credit instruments depends on the extent to which spread compression provides an offset. Here it is important to make a distinction between Investment Grade Credits (IGC) and High Yield (HY) bonds. Historically, this spread compression was not sufficient for Investment Grade credits, leading to higher yields and a negative return. High yield bonds however, thanks to both a higher carry and yield compression, often managed to realize a positive performance. Looking at 15 periods of rising treasury yields since 1988, you can see that, indeed, high yield bonds are able to generate positive annualized returns in an environment of rising treasury yields.
Ultimately, high yield is our preferred fixed income investment, and we recently upgraded our top-down tactical asset allocation to spread products from a small underweight to neutral. However, within spreads we have a clear preference for those market segments that offer the highest risk premium. Our preferred spread products are therefore High Yield bonds and Senior Bank Loans (SBL) while we have a neutral stance on Investment Grade Credits. Emerging Market FX is kept at an underweight position. Relative return momentum is negative as emerging markets continue to struggle with outflows. Growth dynamics are deteriorating compared to the developed markets and result in tighter financial conditions while central banks become increasingly hawkish.
Valentijn van Nieuwenhuijzen is head of strategy at ING Investment Management (ING IM)
Comments