Focus on: high yield and global credit
Central bank monetary policy shifts, growth in electronic trading and evolving risk appetites all look set to be key themes for 2018. Here, managers from Insight and Mellon Capital consider the year ahead.
Do you think there has been a fundamental change in the way fixed income markets operate and how do you envision this playing out this year?
Peter Bentley: Credit markets, particularly further down the capital structure, can suffer from low levels of two-way liquidity. It’s unlikely to change over the next year, so investors may increasingly look at mitigating the issue by widening their opportunity sets to allow access to the deepest and most liquid markets.
Ulrich Gerhard: In high yield, there has been significant participation by investment grade investors in BB-rated credits, in both the US and Europe. Although this had been the case previously, there was a big shift in 2016 and 2017. Should rates move higher, we don’t expect investment grade funds to sell unless default rates increase, which we don’t anticipate. Separately, liquidity remains difficult and it continues to deteriorate. This would act to amplify any sell-off, should one occur.
Claire Corry: Fixed income markets have evolved over the last several years alongside the reshaping of the financial industry. The combination of two key trends – the increased use of electronic trading and the emergence of bond market ETFs – has greatly improved the cost efficiency of bond programme/basket trading, especially vis-à-vis block trading.
In 2018 we’d expect electronic and automated trading to make further inroads and risk capital to remain constrained, yet be priced more efficiently as sell-side desks rationalise. We’d also expect increased demand for beta and smart beta solutions.
What areas are key for valuations in the year ahead?
Peter Bentley: The main factor affecting valuations could be the pace of global monetary policy normalisation. As the Federal Reserve (Fed) reduces its balance sheet and the European Central Bank (ECB) looks to taper its asset purchases, global quantitative easing (QE) will likely slow down materially, meaning less demand for government bonds which can be expected to put upward pressure on government bond yields.
Within credit, (as of Q4) corporate leverage was running at the highest levels since the financial crisis and credit spreads were at some of the tightest levels for three years. The situation is clearly cause for concern but the good news is that default rates are historically low and likely to stay low given the still-accommodative monetary policy regime and the fact many corporates have termed-out their debt. The current credit cycle generally appears to have further to run as corporate profitability continues to recover and as the world enjoys a synchronised economic upswing. The potential for stimulative fiscal policies in the US could offer further support.
Claire Corry: Valuation of high yield bonds is predicated on two factors – interest rate and credit risk. Related to interest rate risk, the withdrawal of central bank liquidity and the expectation of further rate increases by the US Fed could create some headwind for bonds. However, credit risk is the more dominant driver of returns within this asset class. The key fundamental factor in valuing high yield bonds is default risk and, looking out to 2018; defaults are expected to persist at relatively low levels.
Where do you see the opportunity set in 2018 – and where is the largest threat of defaults?
Peter Bentley: European banks are particularly interesting because it’s the only real sector whose leverage metrics are still improving. Asset-backed securities also offer an appealing premium for those who have the capability to analyse them.
In terms of defaults, brick-and-mortar retailers in the US and the UK are currently under pressure from online competitors. Given stability in the oil price, the energy sector is unlikely to repeat its recent woes.
The largest threat would be a sharp fall in risk appetite resulting in investment grade buyers heading for the exit. Relatively low liquidity could exacerbate a sell-off. However, it would unlikely be driven by fundamentals since defaults are at record lows and the outlook for them remains benign.
Ulrich Gerhard: We view default rates as the largest threat. In the US and UK retail sector, the business model is changing as online continues to grow, while in the UK sterling weakness is also having an impact. As for high yield returns overall, the largest threat is spread widening but we think there’s a decent cushion to absorb rate hikes, especially give the low default rates.
Claire Corry: To get an idea of the areas with the largest threat of default, you can look at bonds trading at distressed levels. On this measure, the two sectors with the most exposure to distressed securities are retail and energy. Given the defaults in the retail sector in 2017, we could envisage a further shakeout. However, in the context of the bigger picture, combined default risk from these segments is relatively small.
We view the general economic environment as being very supportive of high yield bonds. Overall growth is positive not only in the US but globally as well. Corporate earnings are generally stable or positive, providing the ideal backdrop for generating positive returns. Having said that, we also know that the geopolitical landscape is quite volatile and periods of risk-off sentiment are expected. Short of a more extreme recession scenario, we believe these periods will provide favourable entry points into high yield.
Do you foresee any renormalisation in yield levels and opportunities or will high yield returns continue to be muted?
Claire Corry: While returns for high yield might appear muted (particularly when compared with equity returns over the past year) they remain significantly higher than cash. Also, returns and return expectations have to be taken in the proper context. We’re in a world where central banks are only starting to think about taking their foot off the pedal. It’s also a world with low interest rates and inflation, and modest growth potential. In our view, with the end-of-year, across-the-board asset price appreciation, future returns from all asset types will be lower. Given this, we still believe HY returns will be competitive.
Peter Bentley: We think government bond yields are likely to increase over 2018 as global growth ticks up and central banks look to make steps towards policy normalisation. In our view, the rise in yields is likely to be gradual and at best will settle around a ‘new normal’ (which the Federal Reserve estimates to be 3% in the US in terms of policy rates). In the grand scheme of things, this implies a pretty modest increase in yields. Credit markets should remain largely unaffected as a result.
Ulrich Gerhard: We anticipate yields rising somewhat in both Europe and the US in response to central bank activity. However, we expect the ECB to be aware of the constraints faced by some of the countries on the periphery of the eurozone, which may lead it to hold back from full normalisation. BB-rated credits seem vulnerable, we think, given the ultra-low yields in Europe and significant ownership by investment grade funds.
What’s the outlook for duration positioning given the direction of central banks?
Peter Bentley:In our view, a bias towards short duration positioning appears attractive right now given the market's apparent reluctance to price continuing normalisation of central bank policy. However, yields have largely been range-bound this year, so tactically adjusting positioning could ultimately be beneficial.
Claire Corry: Over the past few years we’ve seen the emergence of short duration and of buy-and-maintain products. Overall, though we believe high yield is one of the better places to be, as duration within the space is naturally lower. Further, the sector is more influenced by equity markets, where rate rises are construed as positive indicators of an improving economic backdrop.This is not investment advice. Regulatory Disclosure