Bond conundrums – finding value
By Kira Nickerson, BNY Mellon IM EMEA
Although interest rate hikes are expected in 2015, the timing of such action is an unknown while the extent of a market reaction (or lack of one) when it happens is a mystery. Here April LaRusse, senior product specialist at Insight, looks at the state of credit attractiveness for the year ahead, irrespective of policy surprises.
The credit sell-off in September and October 2014 helped bring valuations to more attractive levels but yields remain low and LaRusse expects in the aftermath they could move lower still. As hunger for yield continues it could lead investors into different, less mainstream and illiquid areas of the fixed income universe, although perhaps less so than in 2014 given the autumn 2014 sell off in conventional bonds. “If we see another bout of risk aversion and high yield was to get back to say 6-7% yields then yes, more attention would probably shift back to ‘mainstream’ fixed income assets. The main reason for looking outside of ‘plain’ corporate or government bonds and into more esoteric and/or illiquid instruments or low level credits has been the hunt for yield.”
LaRusse believes investment grade credit looks more attractive post the autumn bond sell-off and feels the environment ahead, even if growth remains anaemic, looks well suited to the asset class. “One of the best environments for corporate bonds is trend growth – well above trend and companies start to behave recklessly and start increasing leverage, too slow and may struggle to service their debts.”
Another area that looks attractive for 2015, given the expectation of continued low yields, is securitised corporates, issues that use a physical or tangible asset as collateral backing the bond. Issuers in this space include the likes of the Channel Tunnel, BT, Canary Wharf, the BBC and the UK Housing Association. “These types of bonds are attractive for two reasons. First of all, the additional complexity means they tend to have a higher yield than an unsecured bond issued by the same company. In addition the language within the bond typically limits how much leverage can be put into the structure."
Although interest rate rises are seen as unhelpful for bond markets, LaRusse believes companies are more than capable of coping with what are likely to be only slight increases. Many companies in the UK and US (and Europe to a lesser degree) are generating solid free cash flows so they are able to service debt and also can pay it down, she notes. “Typically rates go up because growth is strong so companies can tolerate initial moves and we expect any rate move in 2015 to be small, not enough to cause difficulty.” As such she expects defaults will continue to benign for some time yet.
For defaults to rise significantly from current low levels it would take something like a recession (perhaps caused by tighter monetary policy) or a paralysis in the capital markets making it impossible for some companies to cover their obligations, she comments.
She believes aggressive monetary policy tightening is unlikely for 2015 as the inflation picture looks unremittingly good. “There is no inflationary reason to hike rates right now and so long as it remains below central bank targets there will be no rush. Indeed even if it did become an issue it is possible central banks may even use other instruments –macro prudential policies – to tackle it. The Bank of England has already indicated it may look for other solutions to slow down sections of the economy without using the big hammer of interest rate moves.”
New issuance is likely to continue through the year although with the spectre of higher rates the impetus for refinancing is slightly less than in 2014. However, LaRusse says ‘lower for longer’ rates and the continued tight lending environment means bond issuance will remain be a noticeable trend in fixed income through the coming year.
Going with the flow…
Because investor demand for yield will still be strong in 2015 the recent watering down of covenants for both high yield and loans is another development expected to continue. In July it was reported that the US had seen US$260.1bn of issuance in 2013 and US$129.6bn through early June 2014, according to Standard & Poor's Leveraged Commentary and Data unit – far above the pre-crisis peak of US$96.6bn of issuance in 2007. 1While weaker investor protection is never welcome, LaRusse points out investors put up with weaker protection in their demand for yield, providing little motivation for companies to tighten covenants.
Liquidity is also not projected to improve markedly in 2015 but LaRusse says bond investors are becoming used to this situation and have adapted. “Given how little extra yield investors get from investing in a corporate bond over and above a government bond, you are not compensated for unexpected deterioration in the credit quality of the business or a sudden increase in market volatility. As such you have to be careful what you invest in and ensure it is an improving company with solid fundamentals.” This means flexible bond funds need to be even more nimble in positioning, with managers sometimes moving earlier in a trade than they would have otherwise. “Anything substantial in size may take longer to move.”
So what will hinder fixed income for 2015? It is hard to see, according to LaRusse. Rate rises are unlikely to cause too much stress but as the October volatility proved, the market could be easily spooked. This means duration positions will have to be more fluid, LaRusse says. For instance heading into the final quarter of 2014 markets had practically removed all expectation of a future rise in interest rates – having gone from too much anticipation of a rate move earlier in the year. This will change again and it could happen rapidly, she adds. The inflation picture, while good, could be affected by the kind of winter we have and the demand it places on oil; but how authorities contend with inflation if or when it does appear will be closely watched.
1. Wall Street Journal 21 July, 2014: Shining a light on covenants