With Mario Draghi extending the ECB's QE programme this month, and investors returning to US high yield following a number of recent sell-offs, managers tell Investment Week which areas of the credit sphere are likely to outperform in the coming months and why.
Eugene Philalithis, portfolio manager, Fidelity Multi Asset Income fund
US has extended 'maturity wall'
We are most positive on US high yield, which continues to be supported by the ongoing economic recovery. It also benefits from an extended maturity wall, meaning relatively few companies have to refinance their bonds this year, or even in 2017.
While concerns around the energy sector continue, this accounts for a relatively small (and diminished) part of the index. We also have a favourable view on European high yield, though the relative merits of the asset class are less attractive than US high yield.
Outside of Europe and the US, we also see opportunities within local currency EMD. This asset class currently offers attractive yields, both nominal and real, while the scale of EM currency depreciation seen thus far provides some margin of safety for the future.
Seamus Lyons, senior investment manager, Architas
QE extension a tailwind
Concern about energy markets and a preference for higher quality exposure is driving our high yield allocation, where we favour Europe over the US. The European market has significantly less exposure to lower rated high yield issuers than the US, and a naturally higher quality across the board.
In addition, we are concerned about the sustainability of the current recovery in the energy market. US high yield may have outperformed in the past month, driven by a perceived stabilisation of the oil price, but this does not address the long-term supply/demand imbalances.
Europe, on the other hand, has much lower exposure to energy and basic materials. The latest extension of QE by the ECB, and the move to include non-bank corporate bonds, will also provide a good tailwind for the already positive outlook for high yield in Europe.
Iain Stealey, manager, JPM Global Bond Opportunities fund
US default risk priced in
Our allocation to US high yield includes higher quality companies and avoids beaten-down energy and mining names. That said, we think default risk has been fully priced into the market and investors are being well compensated for holding US high yield on a risk-adjusted basis.
European high yield, however, is even more attractive on a fundamental basis and has outperformed its US counterpart market for the last four years. It also remains earlier in the credit cycle and will continue to be supported by the ECB, whose latest round of measures were nothing short of stunning.
With the fundamentals globally still looking quite challenging (low growth, low inflation and leverage in many parts of the world that has increased rather than decreased since the crisis), there is, presently, a positive environment for fixed income assets.
Andrew Birt, head of research, Saunderson House
US spreads will compress
The US dollar high yield bond market currently offers yields that are circa 320bps higher than those on the euro high yield market. Of course, this reflects higher government bond yields and a larger weighting to commodity producers in the US but, in our view, the dollar high yield market is already pricing in a lot of bad news on interest rates and defaults.
US credit spreads will compress relative to those in Europe, even with the tailwind of the ECB buying of eurozone corporate bonds.
This view is partly a function of the degree to which the US high yield market has underperformed its European counterpart since November 2014, but also reflects our belief that, in a world where interest rates are likely to remain low for years, investors will continue to reach for yield.
James Klempster, portfolio manager, Momentum Global Investment Management
US spreads still above fair value
For us, the best opportunities remain in US credit, especially in the mid-quality end of the credit spectrum. US high yield has rallied well over the past couple of weeks but, despite that, spreads are still well above what we consider to be fair value.
Sure, there are valid concerns over the energy sector, which accounts for about 10% of issuance here, but last years' sell-off of these securities represented concerns of so much more to us.
At its nadir, it looked as though the market was starting to price in either a systemic issue in high yield, or concerns over the credit cycle being long in the tooth.
While we have come a long way post financial crisis, we do not see the excesses that one would associate with either risk. At today's spread of nearly 6.5%, we believe there is merit in a high yield allocation for investors as this is an attractive level of reward for the levels of defaults we expect from this asset class.
Simon Brett, chief investment officer, Parmenion
Risk of non-energy defaults should fall
In a low yield world of investment, the search for any type of income has become a rallying cry for investors. And with glacial rises in interest rates expected in the US and the UK, the problem is not likely to abate any time soon.
The announcement by the ECB last week that it will purchase euro-denominated bonds should lower yields and allow eurozone companies to borrow more cheaply, and hopefully invest and spend.
As QE has come to an end in the US, the high yield sector looks appealing with rates of 8% available. No doubt the high yields on offer are partly a reflection of the travails of the energy companies and their risk of default, but that sector only accounts for 15% of the asset class.
With the US showing steady signs of recovery, the risk of defaults from non-energy issuers should lessen, and thus the yields available look more attractive than Europe.
Fraser Lundie, co-head, Hermes Credit
Focus on industry not geography
We remain constructive on higher quality US high yield, particularly basic industry, autos and auto parts, where opportunities have presented themselves in solid, improving credits that sold off in sympathy with oil.
Indeed, for some, lower oil is in fact a tailwind. When combined with exposure to the still-robust US consumer, the market appears attractive when compared with euro high yield, where relatively higher exposure to banks and a lack of illiquidity premium on small-scale corporates leave us cautious at current valuations.
Most importantly, the decision on Europe versus US is now a bottom-up one, ie, at a security, company, or industry-level.
As corporates have more of a global footprint than ever, fund themselves in multiple currencies, and compete with each other regardless of domicile, credit investors are compelled to follow because investment silos based on geography amplify investment risks rather than mitigating them.
Marina Jelesova, associate portfolio manager, Morningstar
Selection is key
Credit is well positioned to deliver reasonable risk-adjusted returns for long-term investors. In Europe, the inclusion of corporate bonds in the ECB purchase program has led to an imbalance between supply and demand, and should tighten credit spreads. Spreads between German bunds and peripheral bonds should also compress.
However, yields are low on an absolute level from a historical perspective and this could cap performance. In this respect, the European high yield market is well positioned: underlying corporate fundamentals are sound and default rates are expected to remain low for the foreseeable future.
The valuation argument in the US market is even more relevant but one must be selective: dispersion is high between sectors and data suggests some recent deterioration in credit quality. US investment grade is a good compromise, still offering good value and a better credit quality.
We also see considerable long-term opportunities in emerging market debt among higher quality credits: many countries benefit from lower oil prices and only a few are in recession.
Tim Haywood, investment director, GAM
HY energy still profitable
Energy markets remain a hot topic in the investment universe, with oil prices a significant directional driver for most asset classes.
We foresee a balance between supply and demand manifesting by year end, and there has recently been a swing in speculators changing their positioning from short to long. The market may significantly front-run any hard news of a shift in the supply/demand balance.
Within the fixed income universe, high yield energy bonds have rallied eight points so far this month, making them a small but profitable holding. We are positioned with positive spread duration, so are long corporate bonds.
This asset class currently offers a level of yield that implies a significant number of defaults, which seems unlikely given the environment of gentle recovery. Corporate bonds, particularly within the energy sector, have struggled because of this negative impression but are starting to pick up.
We have been rotating out of stable names into bonds where the recent price collapse is at odds with underlying fundamentals.
Patricia Schuetz, senior client portfolio manager, Pictet Asset Management
Europe recession still likely
Volatile markets, like we are currently experiencing, provide attractive investment opportunities for unconstrained global managers focused on long-term, value-based strategies. Diversification of these strategies though is critical in building a robust portfolio for these markets.
We have been shifting our positions to favour the US versus Europe, where valuations are increasingly stretched and the probability of a recession is increasing.
We are underweight core Europe, and have reduced our long peripheral sovereigns in favour of credit. The move by the ECB is positive for credit overall, where we remain overweight subordinated financials in Europe.
We have added US high yield both via cash and indices. While the extended QE programme has created a positive momentum, rather than chasing the market at this point, we are monitoring the value in current holdings and evaluating market developments with the aim of keeping a highly diversified portfolio.
Robert Lee, executive director, Signia Wealth
QE extension positive
The decision to include investment grade euro-denominated bonds issued by non-bank corporations established in the euro area under the asset purchase programme umbrella is a clear positive for the sector.
By introducing a regular marginal buyer of significant size to compress credit spreads, it improves the convexity profile of the market relative to the global market. This is also as European Central Bank purchases reduce the elasticity of European bond prices to rising global credit yields.
This provides a key benefit for global fixed income managers investing in European credit, as reduced correlations to other asset classes opens the door of a surplus risk budget to harness carry from a cheap US high yield market.
This strategy has its risks, as the sector is increasingly earning its name as a junk bond market. Leverage is uncomfortably high and ticking up, illiquidity is rife, and energy market spill-over risks remain. However, attractive risk-adjusted opportunities persist for those who can spot them and those who can afford them.
Andrew Jessop, MD and high yield portfolio manager, PIMCO
Despite the recent rally, US high yield remains an attractive opportunity, especially with yields above 8%. Over the last two years, there has been a general widening alongside large outflows, concerns over exposure to the commodities sector, and uncertainties about global growth.
In our view, most of these fears are overdone. We expect modest positive growth and inflation in the US; an environment in which the high yield asset class tends to perform well.
We are investing in sectors such as healthcare, pharmaceuticals, and media cable which are more defensive in nature, benefit from secular growth stories, and offer compelling risk-adjusted returns.
The case for high yield bonds over equities is particularly compelling because they are currently yielding above the 6% to 8% range investors typically target for equity returns and have provided better downside protection, delivering equity-like returns with significantly less volatility and drawdowns.
High yield bonds also have had a low correlation to other asset classes, particularly government bonds, making them an attractive portfolio diversifier.
Azhar Hussain, head of global high yield, Royal London Asset Management
Short duration HY
We have been overweight European high yield based on its fundamentals but have had concerns on its technicals over the course of the last year as illiquidity in many of the constituents has led to a huge amount of volatility.
We do not think the ECB's actions in the investment grade market will change the fundamental picture much, but it is likely to make the technical picture even cloudier at a time when the US high yield market away from energy and commodities is starting to look more attractive.
We still think the front end of both markets (including high coupon callable paper) provides the best risk adjusted opportunities. Short duration high yield is likely to give a better return this year with a lot less uncertainty.
Mauro Ratto, head of emerging markets, Pioneer Investments
The ECB's move should further reduce European corporate yields, while also squeezing liquidity in the broader credit space. Against this backdrop, the returns available in emerging markets, particularly in credit, stand out strongly.
China's shift in monetary policy has attracted a wide range of comment, though we remain confident in the capability of policy makers to deliver a soft landing. In Latin America, we are watching developments closely after a period of ratings consolidation last year. Even with these concerns, EM offers real growth and real rates.
EM can also offer shorter duration exposure versus peer asset classes. That means that EM can offer appealing curve exposure to a broader, blended portfolio. If you believe that the likely trajectory of US rates is probably upward, then adding shorter duration exposure might be appealing versus lower income and longer duration in European sovereign.
Two further points support EM. One is that issuer fundamentals off benchmark are often offer better priced than their benchmark peers. And second, a number of EM sovereigns offer much higher yield than equivalent European sovereigns. The market's skepticism towards some of these names might change over time with fundamental improvement and technical support.
Noelle Cazalis, assistant fund manager, fixed income team, Rathbones
Neither Europe or the US – look at the UK
It has been a challenging few months for global subordinated financial debt, but we feel this is overdone. Indeed, the missing piece of the jigsaw for subordinated financials was sentiment, and Draghi helped restore that last week.
UK banks and insurers that we hold posted strong results this year, but investors ignored this, distracted as they were with fears of recession and troubles with the European banking system. In fact, most UK banks have recently surprised investors with better-than-expected asset quality and capital positions.
But these spreads have widened regardless. We took advantage of this dislocation to add to UK names ahead of the European Central Bank meeting, including Coventry Building Society and Principality Building Society bonds – two of the most highly capitalised British financial institutions – at yields of more than 10% and 7.7% respectively. We also added to Barclays Lt2 and Lloyds LT2 holdings.
Jon Jonsson, manager, Neuberger Berman Global Bond Absolute Return fund
We think last week's announcements from the ECB were game-changing. Markets were concerned that central banks had reached the limits of policy effectiveness. Mario Draghi did say that this may be the end for rate cuts but he added that the many other measures introduced signalled a shift of emphasis from rates to "non-conventional instruments".
We think there were hints at co-ordination with other central banks on an end to using the FX channel for stimulus.
This is good news for risk assets and banks in particular. These moves signal an ability to add stimulus without hurting banks' profits, so we will re-assess our position favouring US banks over European.
We have added to high yield in the last few months, both US and Europe. Further additions are likely to be expressed in Europe where spread tightening had lagged. Despite significant tightening on Friday we feel there is further to go.
Finally, if markets anticipate a return of inflation European yield curves should steepen. That view can be expressed on European curves or with a long-US short-Germany position at the 30-year point.
Hinesh Patel, portfolio manager, Old Mutual Global Bond fund
Local bonds in Australia and NZ
A couple of years ago the decision between US and European high yield was straightforward – unequivocally long fixed income in Europe. Since then, we have lived through an increasing number of shocks in markets.
Investors are dealing with balance sheet liquidity constraints, tighter risk budgets and uncertainty everywhere they look; across domestic policies, geopolitics, global growth and inflation.
To illustrate the consequences, Germany's February 2024 maturity government bond had ten three-sigma price moves during the last 12 months. Statistically a three-sigma move should occur once a year.
By comparison, the S&P 500 equity index had half as many three-sigma price moves. Large swathes of the European bond market share this experience – especially in the sovereign space – where returns fail to compensate investors for any level of volatility.
Quite simply all risk and no reward. Today, you can see the next wave of the monetary policy divergence play out but the regional allocation decision is far more nuanced. Both can provide benefits however.
In Europe we prefer areas of the market that offer attractive relative valuation, whilst the US we seek income generation and positions that work as hedges or portfolio insurance.
Our best performing bond positions have been related to monetary policy expectations and QE. Top of the pack sit Japanese government bonds. Increases in the Bank of Japan's asset purchase programmes created a shortage of local bonds. Exacerbated by declining issuance this drove bond prices to all-time highs.
An added benefit was a dampening of portfolio volatility through this year's risk-off episodes. Along the QE theme, Italian government bonds also performed well and remain our largest allocation in Europe.
In the US, we think inflation-linked securities offer good opportunity. In our view, this part of the fixed income has lagged the move in commodities and is pricing a much too benign view of future US inflation.
We remain underweight/short the belly (5-10 yr sector) of the US curve as term-premium remains negative and expect Fed hike expectations to resurface. Local bonds in Australia and New Zealand are good examples where real yields remain positive, thereby generating positive real income and simultaneously providing a downside hedge in an adverse global growth or risk-off scenario.
Ryan Myerberg, portfolio manager, Janus Capital International
Value in both
We continue to see value in both investment grade and high yield European credit following the ECB's decision to add corporate bonds to its QE program. Its pivot away from a focus on rates to asset purchases and TLTROs is likely to be positive for both the real economy and banks; in particular we like Irish and Italian sovereign debt and the subordinated debt of select European banks.
In the US our sanguine economic outlook means we find owning longer dated TIPS compelling, and pockets of the US corporate bond market look attractively priced.
There is no substitute for doing the fundamental credit analysis on a company by company basis, however, as the penalty for miscalculation is compounded in a low-liquidity environment.
Lastly, in a world of low to negative rates we like countries with attractive carry and accommodative central bank policies, such as New Zealand.
Nick Hayes, manager, AXA WF Global Strategic Bonds
We maintain a preference for US high yield where our allocation was at 21.9% at the end of February 2016. With spreads at 682 bps versus 518 bps for European high yield, the asset class offers attractive valuation and opportunities to add value through security and sector selection.
The improvement in sentiment has benefitted US high yield this month, and it has so far outperformed European high yield.
The ECB announcement that it will include euro investment grade corporate bonds as part of the eligible assets for its purchase programme, should prove a short-term positive for European credit.
However, we believe that this could increase the divergence between fundamentals and valuations and reduce liquidity over the medium-term in Europe.
Investors may now have to take additional credit risk to satisfy their yield requirements, and we expect clients to take advantage of higher yields and re-allocate to US corporate bonds over the course of 2016.
Richard Lindquist, head of high yield, Morgan Stanley Investment Management
Europe single B credits
As Draghi extends the ECB's QE programme and investors pile back into US high yield, we are finding the best opportunities in fundamentally solid single B rated middle market credits that sold off on very little volume, and in sympathy with the rout in energy and commodity related credits, as well as with the forced selling by ETF's of larger capitalisation credits to meet redemptions.
These single B middle market credits were trading at spreads and yields indicative of an economic recession in the US. As investors have recently become more convinced that the US economy is not headed into a recession, recovery in spreads and yields have begun for this segment of the high yield market but we believe the spread tightening still has a ways to go to get back to a more normalised non-recession relationship to double B spreads.