A bond for all seasons
A strong couple of years on bond markets has seen expert credit selection become ever more important.
Some equity investors pay only passing attention to macroeconomic developments; the same cannot be said of credit investors. The primary concern of a credit investor – the likelihood a company could default on its debt – is undoubtedly sensitive to the direction of the broader economy.
In which case, you might think fixed income investors should be worried just now. Business cycles in the past have tended to last around eight years. If that pattern was repeated, then a recession shouldn’t be far away. Or so goes the argument.
“I think most investors in the fixed income space have revisited that refrain recently,” says Brad Boyd of Payden & Rygel. “But we don’t fall in that camp. If you look at the actual data, unemployment across the globe continues to come down further and further. Earnings are very strong, and both GDP and inflation are stable.”
What is not in doubt is that bond prices have risen considerably in the past two years, pushing down yields. High-quality corporate bonds in the UK, for example, have risen in value by more than 15% since the start of 20161 – a strong run for the fixed income sector. It is a trend that’s repeated across the developed world, as rising prices push down bond yields.
“There were double-digit returns on offer in 2016 but spreads have since tightened against US Treasuries,” says Don Morgan of Brigade Capital Management. “So from a valuation perspective on the market overall, there is less opportunity. Having said that, there’s always something for us to do in any market. Whereas in February 2016 we were looking at slightly higher-risk credits, today we think you are not being adequately compensated for that risk – and so we’ve moved into a slightly higher-quality part of the market.”
Selectivity need not only apply to quality levels, of course – it can also be applied to credit sectors. While some areas of the bond market have seen prices mount significantly, others have remained relatively calm. In more expensive markets, moreover, your buying discipline becomes even more important. For Brad Boyd, this means thinking ‘broader, steeper and newer’.
“Thinking ‘broader’ means looking in some sectors that you don’t typically uncover, like the asset-backed and mortgage markets,” says Boyd. “Thinking ‘steeper’ means maximising the yield by finding the sweet spots on yield curves globally; and thinking ‘newer’ means taking advantage of the new issue premium that you get when corporations and countries issue new debt.”
One reason Boyd likes the asset-backed securities (ABS) and mortgage-backed securities (MBS) is price, but another is the high level of protection they offer compared to typical credits, which is a function of their design.
“In a typical corporate bond, you have a binary outcome – usually the company pays the interest, but you can also have a jump to default,” says Boyd. “In the case of ABS and MBS, your security is backed by a pool of loans – many, many thousands of them – and so you don’t have this jump to default in a negative case. There’s more predictability and protection. Instead of being reliant on one particular company, you’re talking about thousands and thousands of loans, so it’s more about analysis of the overall economy.”
Some investors are concerned that, as the market gets stronger, it may also be overheating – along with the broader economy. One potential sign of this is that covenants – the terms and conditions that bond sellers attach to their product – have got considerably weaker in recent months. A similar trend was discernible prior to the financial crisis. However, the comparison looks less meaningful in the broader context.
“We are indeed seeing a similar percentage of covenant-lite deals as we did in 2006-7; however, the absolute leverage of companies is lower than it was then,” says Morgan.
Morgan likes the energy sector, but also prefers to avoid strong sensitivity to swings in commodity prices, pushing him towards oil services companies. Weatherford and Transocean are two particular favourites, since they also offer a high yield of around 7-9%.2 Moreover, he doesn’t see the industry suffering from imminent technological disruption – unlike many other sectors.
“Never in my career since the late ‘90s have I been more worried about secular changes in industry or rapid technological change,” says Morgan. “Every time we look at new high yield issuers, we have to take a step back and ask if the business is even going to be around in 10 years, given what’s happening with Amazon, Uber, self-driving cars and so on. We’re really looking for companies with strong enough business models to prevent them being sidelined by new market entrants.”
Payden & Rygel and Brigade Capital Management are fund managers for St. James’s Place.
The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.
The opinions expressed are those of Brad Boyd of Payden & Rygel and Don Morgan of Brigade Capital Management and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or adopt a strategy. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.
2 Source: Morningstar