Home / How credit can satisfy thirst for yield amid European gloom

by Phil Miall, Head of Credit Research & Strategy, QIC

Superannuation funds’ return objectives will become harder to hit through beta alone on the heels of an intensification of the ECB’s quantitative easing program and a clutch of central bank interest rate cuts. Selective credit market investments, including high-yield investments in the beaten-up US energy sector offer potentially attractive risk-adjusted returns and can go some way towards helping funds meet their overall return objectives.

The New Year has already provided plenty to digest. After criticism that it wasn’t doing enough to fight against unusually low inflation and economic lethargy, the ECB has committed to buying around €60 billion a month in bonds from March 2015 and continuing well into 2016.

Meanwhile, national central banks seem to be in a race to see who can push down official interest rates fastest and deepest. Central banks from countries as disparate as Canada, Switzerland, Denmark and Australia have been members of the rate cutting club of late.  A common theme uniting them is a desire for lower currencies to assist economic competitiveness.

All this rate cutting and quantitative easing has been making an impression on bond markets.  A case in point: the value of government bonds, including those of Germany, the Netherlands and Switzerland trading with a negative yield (Figure 1) hit US$3.6 trillion earlier this month, or around 16 per cent of the JPM Global Government Bond Index.

This poses serious problems for funds required to achieve rates of return somewhere 3-4 per cent north of cash rates.

We think investing in credit is part of the solution. Credit markets have been a rich source of yield in recent years, but the easy gains that investors have become accustomed to will be a thing of the past.

In the years immediately after the GFC it was possible to ride the US credit benchmark to higher returns. But benchmark-like investing is no longer adequate. As a generalisation, companies are still being careful with their finances, but credit fundamentals have probably peaked in a number of markets.

Increasing dividends, buybacks, capex and M&A activity have been features of corporate America, especially investment grade companies. This has not aggregated to a market-wide deterioration in credit conditions rather it’s more a case of a gradual migration of strongly-rated companies towards slightly lower investment grade ratings. We expect this trend to continue as companies take advantage of extremely cheap debt to fund their corporate initiatives.   

Opportunities in markets are likely to appear and fade quickly.  Consequently, investors have to dig deep to understand issues on a region-by-region, industry-by-industry and security-by-security basis and move fast.

Credit investors attuned to this swung into Europe last year, but that’s a macro trade nearing the end of its life, from our perspective. Spreads are tightening and valuations creeping up.

More recently, the disruption wrought by falling oil prices is particularly intriguing. Sharply lower oil prices are a boost for consumers, akin to tax cuts and the outlook for consumer discretionary companies is encouraging. Consequently, consumer cyclical names deserve a close look.

The US energy sector is, naturally, faring less well and the energy exposure of the US high yield market has risen sharply over recent years. The value of high yield energy sector bonds has more than doubled in size since 2011 and now comprises around 13 per cent of Barclays’ US high yield cash index.

Operational cash concerns, which had started to hit exploration and production and oilfield services companies towards the end of last year, could become more severe. However, it would be a mistake to assume that all high-yield energy companies will suffer equally.

Low cost and integrated producers are, for the most part, well placed to weather lower prices while others operate in areas such as oil infrastructure, storage and pipelines and exhibit less volatile cash flows.

Forensically discriminating between companies with credit ratings that run the risk of migrating down, or perhaps even defaulting, and those that can retain, and in time even improve their ratings will be pivotal.

Asian credits are still viewed as exotic by some, but our coverage of the region’s companies suggests that they deserve to be part of institutional portfolios. It’s a market that has progressed rapidly, yet not received commensurate attention.

The USD outstandings of the Asian credit market was valued at US$30 billion in 2005 and grew to US$180 billion in 2014. [1]  Asia offers diversification opportunities from Australia’s famously financials-heavy corporate bond market. Only around 3 per cent of Australian issuance can be categorised as non-financial ‘corporate,’ a far cry from Asia’s impressive 59 per cent level.[2] 

Asia also represents an attractive way of accessing emerging markets’ dynamics. East Asian countries, including South Korea, Taiwan and China boast more encouraging economic fundamentals than African, South American and Eastern European economies, as a generalisation.

“May you live in interesting times” is an English expression purporting to be a translation of a traditional Chinese curse. Although the saying is apocryphal and there is no evidence of actual Chinese origins, it would nevertheless resonate with investors.

There are plenty of potential risks to side-swipe markets. In no particular order: A possible Greek exit from the Euro; Europe’s capacity to maintain cohesion amid popular dissatisfaction with austerity and a congested election calendar; conflicts in the Middle-East and Ukraine; the direction of the oil price; central bank actions; and less capacity for banks to intermediate and act as shock absorbers owing to regulations like Dodd-Frank. The list is lengthy, incomplete and exhausting.

It’s also an environment that should place a premium on investment skill and research and the ability to act dynamically.  In other words, the world we are anticipating should offer good selective opportunities for credit investors.

 

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