Convertibles now key for Algebris, as rising inflation and falling yields loom over credit markets
Convertible bonds and certain cyclical credits in developed markets offer positive opportunities while broader credit markets face a squeeze from rising inflation, negative yields and increased government intervention, according to Alberto Gallo, head of global credit strategies at Algebris Investments.
Following the Covid-driven disruption last year, markets are now in a “state of euphoria”, underpinned by a combination of strong growth and subdued inflation, Gallo observed in Algebris’s ‘Silver Bullet’ market commentary this week.
But after a multi-decade bond market bull-run, roughly 60 per cent of global bonds now yield less than 1 per cent, while most bond portfolios, balanced portfolios and fixed income funds are “positioned the wrong way”, comprising assets that offer little protection from either gradual rising inflation or rapid market sell-offs.
Governments on both sides of the Atlantic are jettisoning ‘QE infinite’ in favour of increased government spending and greater economic support from central banks post-Covid, said Gallo, pointing to US President Joe Biden’s far-reaching tax-and-spend proposals and the EU’s Next Generation EU Recovery Plan.
Gallo, who is also portfolio manager of the Algebris Global Credit Opportunities Fund, believes fixed income investors now face a tricky mix of tight spreads, rising rates, and a flurry of summer risks. And with high yield and emerging markets now yielding less than 5 per cent in USD terms, “even small moves in rates have the potential to turn into negative returns”.
As a result, “we believe investors should consider alternatives to their allocation,” he wrote.
Algebris’s Global Credit Opportunities strategy – which trades bank debt, sovereign bonds, and investment grade and high yield corporate debt long and short – is now eyeing certain securities linked to real assets and cash flows, “while we maintain a neutral duration and a very selective allocation to credit.”
Specifically, Gallo pointed to certain opportunities in selected cyclical B-rated credits in developed markets, as well as convertible debt, which is now the top asset class in the Global Credit Opportunities strategy with a 20 per cent allocation. Emerging markets still give cause for caution, though certain areas offer select pockets of value.
“Airlines, cruises and some carmakers are still discounting scepticism on economic re-opening, even in cases where government support is strong or liquidity abundant. The risk premium is higher in Europe – while most of US re-opening sectors have now priced a recovery,” he said.
He added the presence of convertibles in a bond portfolio can make up for the negative asymmetry offered by credit markets.
“High grade issuers in high beta sectors continue to offer a positive convex upside-downside profile to investors. Issuers with healthy balance sheets in hospitality, energy, or travel sectors can see a strong equity re-pricing in a positive scenario, but have little credit risk in a negative one.”
While “valuations are too high and volatility too low”, a demand rebound coupled with supply bottlenecks could bring volatility back across inflation, yields and risk assets.
“We believe governments will not easily be able to quit from spending and high deficits. Today’s spending programmes will likely result in higher structural demand for commodities as well as services, while increased geopolitical tensions are likely to bring production of strategic goods back on shore, reversing,” Gallo noted. “The result is likely to be continued depreciation of fiat currencies against real assets.”
Multi-strategy credit and equities asset manager Algebris Investments, which was established in 2006 by founder and CEO Davide Serra, an Italian-born former UBS and Morgan Stanley analyst, focuses on a broad range of credit, equity and non-performing loan markets.