There are still plenty of attractive possibilities within credit markets but the fact is that it will be far more difficult for fund managers operating in this area to identify potentially lucrative holdings over the coming year.
That’s the opinion of David Riley, head of credit at BlueBay Asset Management, who believes the combination of a remarkable market environment and a dramatically changing economic backdrop has resulted in a much tougher outlook.
‘There are still opportunities for investors, but managers are going to have to work much harder than they have been in recent years in terms of generating strong positive real returns for their clients,’ he says.
A key reason for this is changing economic policies.
‘This year we could see a synchronised recovery in growth prospects across the globe on a footing that seems more sustainable than in 2010’ – Wes Sparks, Schroders
‘If we’re moving to an environment where central banks are looking to exit from those extraordinary policies and move into a rate-hiking cycle then clearly that’s a more challenging environment for fixed income and credit investors,’ he says.
Despite the general consensus that the immediate future is characterised by low policy and market volatility risk, Riley insists there are still some big unknowns out there which could pose a threat over the coming months.
‘One talking point is how much slack there is in economies such as the US and their ability to continue recovering and growing above their long-run trend without that starting to feed through in terms of inflation pressure,’ he says.
Another is China. ‘What’s been encouraging and what we and other investors are taking comfort from is that the new Chinese leadership has recognised the need for rebalancing the economy to reduce reliance on credit and investment-led growth,’ he says.
‘They have set out an agenda of reform to achieve this but it won’t be easy.’
Any discussion about the prospect for global credit needs to be set in the context of the last few years, according to Wes Sparks, head of US fixed income and lead manager for global high-yield portfolios at Schroders.
‘The global financial crisis in 2008 created a synchronised downturn in the global economy, characterised by failing financial institutions, unsustainable fiscal deficits, and a collapse in confidence impairing spending and investment,’ he says. ‘The past five years have been spent addressing these issues.’
The regulation of the financial sector, while encouraging lower bank lending, has resulted in institutions that are much stronger today than they were five years ago. Meanwhile, rising government deficits and debt levels resulted in austerity measures across major economies that are now coming to an end as deficits are back to a more manageable level.
‘Limited availability of bank lending contributed to a widespread retrenchment in the household and corporate sector – this is reversing as the banks are now willing and able to lend,’ Sparks says.
‘Hence 2014 marks a point where we could expect to see a synchronised recovery in growth prospects across the globe on a footing that seems more sustainable than in 2010.’
However, global credit markets can’t be tarred with a broad brush approach as each area must be assessed on its own merits. The fact is that Europe, the US, Japan and emerging markets are positioned at different stages in the credit cycle, he points out, and offer varying investment opportunities to the global credit investor.
‘Having taken the lead in repairing its financial sector, the US should see management teams at banks continue to maintain discipline even as they start to increase lending to the real economy,’ he says.
The eurozone, he adds, has clearly managed to overcome the sovereign debt crisis and even though the recovery is fragile, he expects the peripheral economies to continue improving.
‘Emerging markets should benefit from an improved growth outlook in the developed markets,’ he says. ‘However, there are still pockets of structural imbalance – as evidenced by the banking sectors in China, India and Brazil, for example.’
‘We believe improving developed-world economic data should be positive for corporate bond spreads, particularly if company profits remain supported.’ – Paul Brain, Newton
Although supported by global growth momentum and greater policy clarity, emerging market volatility remains a real prospect, agrees Paul Brain, manager of the Newton Global Dynamic Bond fund.
‘While investment-grade credit remains somewhat correlated to movement in underlying sovereign bond yields, we believe improving developed-world economic data should be positive for corporate bond spreads, particularly if company profits remain supported,’ he says. ‘With short-term rates on hold, high-yield credit remains attractive, given a more positive growth backdrop, limited refinancing needs and low projected default rates.’
Graham Wainer, global head of private clients and portfolio management at GAM, believes that spreads over the risk-free rate are very tight and points out that the Barclays US Corporate High Yield Average spread was at just 3.8% at the end of 2013.
‘This one-way street for the asset class means that successful fixed income investing will require a truly alternative approach for the foreseeable future,’ he says.
Daniel Berg, manager of the DNB Global Credit fund, says it’s important to take into account various influences when making investment calls and he illustrates the point by outlining how he countered his negative views on southern Europe.
‘We have been extremely sceptical towards this area, especially the banks,’ he says. ‘There have been a lot of defaults and a lot of the banks weren’t in good shape. We balanced that with high utility exposure in the same countries and to national champions.’
The end of low-hanging fruit
According to Nick Hayes, manager of the AXA WF Global Strategic Bond fund, we’re getting to the point where valuations are starting to look as if a lot of the easy money has already been made and it will become harder for spreads to continue tightening at the same pace.
Among the crucial factors is the underlying future expectation of interest rates which will determine government bond yields, after which it’s all about looking at the strength of the global economy and individual company names to determine credit quality.
‘Developed market economies are stronger than emerging markets, and within that the US is certainly the strongest engine of growth at the moment,’ he says. ‘The UK is not a million miles behind and Europe is still struggling with some post-peripheral crises. All are on an improving trend but at slightly different speeds.’
The approach to portfolio construction embraced by Hayes starts with the macro, and after deciding whether he prefers credit or government bonds, attention is turned towards the different sectors and individual names. The entire process is very much top down.
‘We like some of the financial sectors, such as insurance, as we have done well out of them and there are still some pockets of value,’ he says. ‘We dislike some of the telco stocks because good quality TMT names are more likely to re-leverage rather than de-leverage in this environment and that makes us more wary as they could possibly be looking after their equity holders more than their debt investors.’
Russ Koesterich, BlackRock’s global chief investment strategist, believes long-term interest rates will continue to rise but further increases will be modest.
He also says duration assets – defined as bonds with maturities in the two to five-year range – are likely to be the most vulnerable part of the market over the coming year.
‘In contrast, longer-duration areas of the market have already seen an increase in interest rates and we expect any further upward rate action in that area to be less severe than was the case in 2013,’ he says.
‘A more stable long-term rate environment should take some of the pressure off longer-duration areas within the fixed income market.’
Meanwhile, Boon Peng Ooi, CIO for fixed income at Eastspring Investments, is expecting a challenging year for Asian bonds, but doesn’t believe a repeat of the 2013 sell-off is likely. In particular, he suggests there will be wide divergences between the performances of Asian bond markets.
They will likely remain volatile so a consistent duration underweight position is not necessarily the best strategy, he says. ‘Shifts in policy expectation could bring about price movements that throw up buying opportunities.’
‘In short, I expect 2014 to be as challenging as 2013. Nonetheless, opportunities exist for investors who are prepared to do their investment homework and strategise effectively’ – Boon Peng Ooi, Eastspring Investments
He suggests that China, India and Indonesia have all recognised the structural weaknesses that 2013’s selling exposed. ‘All have stepped up efforts to address these areas but meaningful structural adjustments will take time and markets perceived as not doing enough fast enough could still be punished,’ he says.
‘In short, I expect 2014 to be as challenging as 2013. Nonetheless, opportunities exist for investors who are prepared to do their investment homework and strategise effectively.’
As far as key economic factors are concerned, markets will pay close attention to the US Federal Reserve in light of its decision to start weaning the US economy off its £85 billion-a-month QE programme, according to Ariel Bezalel, manager of the Jupiter Strategic Bond fund.
‘News that the Fed would initially taper its programme by $10 billion a month was at the dovish end of expectations and was greeted well by bond and equity markets,’ he says.
‘It underscored that the Fed believes the economic recovery still has some way to go and affirmed the central bank’s desire not to relinquish control of the yield curve and cause undue weakness in the economy and markets.’
However, he acknowledges the Fed faces a ‘formidable task’, pointing out the risk that economic data will come in a lot stronger than expected, which could lead to market panic over the pace of rate rises and potentially bring forward expectation for a rate increase later in the year, igniting a 1994-style market reversal.
‘We remain optimistic about the outlook for credit markets in 2014,’ he says. ‘Our bullish case is that economic data broadly meets expectations and the market factors in an orderly process. Under this scenario we believe there is potential for high-yield bonds to produce decent returns.’
In like fashion Chris Higham, who runs a number of portfolios for Aviva Investors, describes himself as still ‘moderately constructive’ on global credit markets.
‘A lot of the factors that have been in place for the last five years remain,’ he says. ‘Very low interest rates continue to be a key driver of the hunt-for-yield trend we’ve seen for the last four of five years which means yields on credit are still pretty attractive to the majority of investors.’
Although he still maintains a slight bias for sterling, which outperformed significantly last year, it’s no longer as strong as it once was because he’s starting to see opportunities in the US dollar credit market, which has previously underperformed.
The key, he believes, is to have a broad opportunity set. ‘You need to have a well-resourced team within your organisation,’ he says. ‘For example, we have an emerging market debt team and guys who spend a lot of time looking at inflation, but you must also have the flexibility to make the asset allocation calls that are needed.’
This article originally appeared in the February issue of Citywire Global magazine