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.
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.”
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