Looking at global Investment Grade (IG) markets performance on a year-to-date (YTD) basis might worry investors, as returns for the past nine months have been negative, while last year at the same time, returns were up more than 6%. Investors, on the other hand, might be encouraged by looking at Europe's and Asia's High Yield market performances, as their total returns are positive YTD at approximately 0.5-2.5% (although the recent past has been less encouraging, with 1.5-2.5% lost over the last three months).
The important question is: What lies ahead? Will 2015 end on a positive note for credit investors or are we heading for the first negative annual credit performance in several years? Furthermore, what should investors expect for 2016? In our view, there are many reasons to have a positive stance for the remainder of the year through 2016. Fears of a growth slowdown in China and its potential implications for global growth, as well as falling oil prices, have weighed on markets for many weeks, but we don't believe that recent developments rule out positive credit returns. Indeed, we see several investment themes that could well prove successful in the coming months and help investors achieve positive credit market performance:
- Focus on yield
- Use global opportunities
- Buy speculative rated acquisition targets
- Take local currency credit risk
- Explore supply/demand imbalance in developed markets
In uncertain times, the focus on capital preservation usually becomes intense, but surprisingly during this period of uncertainty about Chinese growth and weakening commodity prices, high yielding fixed income assets, like European High Yield or Subordinated Financials were able to maintain positive YTD total returns and made the focus on yield a rather defensive approach. Where does the positive performance come from? The high current income of these asset classes works as a buffer against negative price returns from recent spikes in volatility and, thus, generates more stable total returns than their IG rated peers. Therefore, it is not surprising that in times of uncertainty, when economies generate only moderate deflationary growth, as seen at the back end of 2014 and the start of 2015 in Europe, high yield credits outperformed. In one of their recent studies, Bank America/Merrill Lynch pointed out that over these periods, B EUR High Yield and High Yield corporate hybrids performed better than BB EUR High Yield and EUR IG.
In addition, the High Yield market benefits from lower duration than its IG peer. Lower duration offers an extra level of protection if interest rate will start to rise again. The latter could already happen soon if the Federal Reserve decides to increase its target rate at one of its upcoming meetings.
However, the focus on yield clearly does not come without risks. Investors moving down the credit curve should have excellent fundamental credit research skills in place. Recent default rate data should remind us that default rates will not decline forever. By July, Moody's counted 77 defaults worth USD 86bn for 2015 in global high yield, which brings the default rate to a 15 month high of 2.4% (Figure 1). Although the default rate remains safely below the 25 year average of 4.6%, detailed analysis of regional markets, like US High Yield, show that B and BB-rated bonds adequately compensate investors for higher default risk (Figure 2).
Figure 1: Global speculative-grade default rate
Figure 2: Expected returns in the US credit market
Source: BofAML Indices, Moody's
In-depth bottom-up research is only one method to avoid defaults. Another method is to broaden the investment universe from a regional to a global focus. The table below (Figure 3) shows that high yield performance in 2015 has depended very much on the region.
Figure 3: Global High Yield Performance
Source: BofAML Indices, as of 24th September 2015
In order to explore these differences, global research capabilities have become compulsory. A broader and more global opportunity set increases the chance to pick the right credit and avoid regions where credit quality is deteriorating faster, in particular US High Yield.
Focusing on yield and global coverage are important investment themes for the remainder of the year and thereafter, but a well constructed portfolio relies on more than one or two themes, and there are some other interesting opportunities that should also help to generate positive returns in the future. For instance, we see value in the debt of high-yield rated acquisition targets, in particular small regional telecom companies. Many of these companies became targets of IG rated telecom companies that were keen to fill strategic gaps. For instance, in recent years, Vodafone invested in cable operators and, currently an IG Danish telecom operator is in discussions to buy a B-rated cable operator. Clearly, if the credit quality of the acquiring company is much stronger than the quality of the target, bonds of the latter usually rally.
In addition, expertise in currencies helps one to explore investment ideas in local currency corporate bonds. Although we are currently cautious with regard to investments in Latin America in general, we still feel comfortable with Peso bonds of selected solid IG issuers in Mexico if the premium over its USD and EUR bonds are attractive and since we have a positive view on the currency in the intermediate term.
Other simpler strategies, like analysing supply and demand in regional markets should also help investors to outperform. At the beginning of the year, European credit markets rallied strongly due to ECB bond purchases, but began ignoring this support after bund yields hit all time lows in April. Since then, Euro IG corporate bonds relinquished their Q1 outperformance and spreads have leapt to their highest levels since end of 2013 (Figure 4).
Figure 4: Euro Investment Grade, Asset Swap Spread (in bps)
Source: BofAML Indices
In a recent study, Citigroup forecasted that the European fixed income market will shrink by EUR 100bn-400bn in the second half of 2015, which leaves the supply demand situation very favourable for European credit markets compared to other developed markets and should cause a rally in spreads. Furthermore, fundamentals in Europe look supportive too, with GDP at “not too hot, not too cold” growth of 1-2%, yielding excellent conditions for credit markets. M&A volume is less elevated in Europe compared to the US and, therefore, less pressure on corporate balance sheets is expected.
In contrast, supply/demand in the US credit market is much different than Europe. The surge in M&A activities ballooned supply, which put upward pressure on spreads as new issue premiums increased in order to sell the deals into the market. Unfortunately, we do not expect any let up in these developments in the near future.
Nevertheless, the difficulties of the US corporate bond market should not stop investors from generating positive returns in Global Credit. A better supply/demand balance in Europe, outperformance of “high yield“ globally, positive event-risk in the telecom sector and opportunities in local currencies, as well as other credit related investment themes, all present interesting opportunities for generating positive returns, even in a challenging environment, not just for the rest of 2015 but also for 2016. The ECB's QE program will run at least until September 2016 and might get even extended, which should keep the credit-supportive imbalance of supply and demand in Europe alive. Furthermore, the focus on yield will have also its merits next year as the global economic environment remains challenging. However, some reallocation might be necessary next year as Euro High Yield has outperformed US High Yield now by a wide margin and a retracement of spread widening in US High Yield is quite possible. In addition, smaller telecom operators will continue to be attractive targets, as the strategic justification for their acquisition will continue into the next year, along with cheap financing costs.
Lastly, broad and flexible investment approaches offer the opportunity to benefit from non-synchronized global-economic, interest rate and credit cycles. The current year clearly demonstrates that performance can depend very much on the region a portfolio manager is focused on. Globally diverging M&A cycles (Europe vs. US); central bank policies (ECB and BoJ vs. the Fed) and shareholder value approaches (Europe vs. US) make the pick of the right region an important alpha source and increase the likelihood for positive returns in 2016.