It is quite a consensus call to have an overweight position on developed market credit but, says Williams Sels (pictured), UK Head of Investment Strategy at HSBC Private Bank, this still makes a lot of sense…
We would rather be lending to non-financial corporates than to most governments. And with global economic growth probably below a normal pace and very difficult to estimate, we think it is still too courageous to upgrade equities or commodities. High corporate bond issuance activity should thus continue to be matched by strong investor demand, in our view.
1. Fundamentals: positive but unexciting global growth and increased cash balances
Credit does best in an economic environment that is not too hot and not too cold. If economic growth is strong, corporates are tempted to invest a lot, which can lead to a build-up in leverage and ultimately hurt their credit quality. If economic growth collapses on the other hand, lower cash flow can cause default rates to rise.
A build-up of leverage seems a distant threat. In fact, many economists complain that companies are not investing enough. In the US, internal cash flow generation has exceeded investments by about $170 billion per annum since mid-2009, causing corporates to build up a cash pile which now stands at $970 billion according to the Federal Reserve. That is quite a significant buffer and should help ensure that future interest payments are not in danger. Bank lending in the US remains at a healthy pace and institutional investors are showing good interest in buying those loans, even for corporates with relatively weak ratings.
In Europe of course, economic growth and bank lending have been weaker, but corporates have still managed to maintain their cash balances almost unchanged at an impressive EUR 1.7 trillion for the past 18 months, according to the ECB. Spread volatility has therefore been much more a function of risk appetite than fundamentals, which remain solid, at least for non-financial investment grade corporates. We continue to see more risk in bank sector valuations because of their link to the sovereigns, and in European high yield, because of the rapidly weakening economy and the difficulty for weaker corporates to obtain credit.
2. Credit’s valuations and risk/return profile look better than for safe havens, in our view
Safe haven government bonds have rallied far, and bond volatility has picked up recently. In less than three weeks, 10-year Treasury yields have risen by 23 basis points (30 in Germany and 16 in the UK), causing prices to fall and wiping out more than a whole year of yield returns. We think investors will thus look to achieve a higher yield or reduce the volatility of the portfolio, and we believe that credit can offer either or both.
It is clear that the still relatively high spread pickup may add to the attraction of the asset class, even if absolute yields are near recent lows.
We already pointed out that volatility of gilts has picked up recently and is often underestimated. Conversely, investors often overestimate the volatility of investment grade credit. On the right, we compare the two for a variety of maturities in the sterling market.
A 5-7 year corporate bond has historically been about as volatile as a 7-10 year gilt. However, the current yield is significantly higher. Investors who try to achieve a higher yield by going ever further on the gilt curve may find that a 1-3 year corporate bond can actually offer a higher yield and a much lower volatility than a 10- year gilt. The risk/return profile of credit thus looks much better than that of gilts. Of course, defaults could alter this conclusion but they should remain very low for investment grade (and in fact, we have incorporated the historical impact of defaults in our volatility calculations).
3. We prefer credit over equities.
As stated before, we think that the outlook for the global economy remains too uncertain to overweight equities at this stage, and we maintain a neutral allocation with a focus on mega-cap equities with resilient earnings prospects or potential for dividend growth.
We also believe that credit is attractively valued relative to equities. This may come as a surprise to some, as equities are generally considered to be quite attractively valued.
Above, we compare equity volatility with credit spreads – a comparison that is often used to assess the relative attraction of these asset classes. As one can see, even in the US, credit spreads (or CDS levels we used here) are relatively wide when compared to equity volatility.
4. EM provides a way to diversify risk
Risk appetite and economic growth in the developed world are likely to remain low for some time. We believe that this will lead investors to continue to diversify and look to add yield without taking too much extra risk. For similar ratings, EM corporates continue to provide a substantial spread pickup relative to yields in the developed world, even if spreads in there have also compressed.
While we think growth and credit fundamentals in many EM countries are strong, we prefer hard currency (USD) over local currency bond markets as we believe that currencies may remain volatile in the short term.
We think that the recent increase in volatility and the extremely low yields of safe haven bonds make Treasury, gilt and Bund markets unattractive. We think credit can help limit the damage of a potential yield spike as credit allows investors to achieve similar or higher income with a much lower duration. Importantly, corporate fundamentals are generally solid and from a relative perspective, valuations still look attractive in our view. We use a mixture of developed and emerging markets debt to diversify our portfolios.