The credit ship sailed through 2017 with modest positive total returns from both investment-grade and high-yield bonds. In 2018, however, navigation is proving more challenging, as turbulence in equity markets leads to negative returns from credit.
Corporate fundamentals are no source for alarm at present. Leverage levels are increasing, but these are offset by a healthy macroeconomic environment. Elsewhere, the backdrop is less favourable: rising interest rates and a pickup in inflation both present headwinds for fixed-rate instruments, while credit spreads over government bonds are historically unattractive.
Here, we identify two strategies that can benefit, in varying ways, from the solid macroeconomic environment and allow investor to pick up extra yield compared with investment-grade and high-yield bonds.
The first of these strategies is a bit of a mouthful: double-A-rated, sterling-denominated, floating-rate asset-backed securities – or ABS for short. Since the financial crisis, ABS have had negative connotations for investors. This is due in part to the complexity of their structure and their lack of liquidity. Also, the regulatory regime implemented in the post-crisis period has imposed punishing capital charges that deter institutional investors from holding such securities. Together, these factors have led to banks and asset-management firms dominating the investor base.
But the changing market environment is making these securities more attractive. Monetary conditions are supportive: as floating-rate bonds, ABS offer coupons that will rise in line with interest rates – a crucial consideration, give that our economists expect the Bank of England to raise interest rates slowly but steadily over the next three years. The securities also currently offer an attractive yield compared with similarly rated investment-grade corporate and government bonds.
Meanwhile, a supportive macroeconomic environment reduces the default risk in the underlying securities.
Importantly, the behavioural biases against holding ABS are now ebbing. The European Central Bank’s buying of euro-denominated ABS has given the asset class ‘street cred’, and the resulting shortage in supply is encouraging investors to switch to sterling-denominated assets. The regulatory burden is also under review: the European Securities and Markets Authority is examining securitisation requirements, while in the UK the Financial Conduct Authority is due to make recommendations regarding ABS origination in the auto sector; we expect a favourable report on the practice. These are welcome steps towards reducing the cost of holding ABS on balance sheets.
Catching fallen angels
A healthy macroeconomic environment is also beneficial for assets lower down the capital structure. Given their relatively higher risk, investors demand a higher premium to hold these assets. In this regard, one strategy is to examine ‘fallen angels’.
The European Central Bank’s buying of euro-denominated ABSs has given the asset class ‘street cred’.
Fallen angels are formerly investment-grade bonds that have had their credit rating downgraded to high-yield status. Consequently, they are generally excluded from investment-grade indices at the next index rebalance. As mandate requirements may constrain the holding of non-investment grade securities and regulations impose capital charges on insurance companies holding speculative-grade bonds, many institutional investors are required to sell holdings following the loss of investment-grade status.
Another consequence of central banks’ policy following the financial crisis is that their unconventional bond-buying programmes have encouraged companies to raise funds on the bond market to take advantage of low rates. This has inflated the size of the credit markets, with the investment-grade universe growing far greater in value relative to its high-yield counterpart. After a credit downgrade, the forced selling of fallen angels by institutional investors can drive the prices of these bonds below their fundamental values, making valuations attractive. The macroeconomic environment remains supportive for fallen angels as default rates are expected to remain low. Caution is required, however, due to tax changes. For bonds on the lower end of the ratings spectrum, fiscal reform in the US is affecting the ability of companies to deduct interest payments from their tax liabilities. Furthermore, the increasing popularity of fallen-angel ETFs will generate some buying pressure for these bonds. The behaviour of the individual issuers is also a major factor in supporting bond prices: fallen angels are often companies whose objective is to regain investment-grade status by reducing leverage or taking other actions to improve their credit profile, which the market should start to recognise in time.
Credit forms a vital part of any multi-asset portfolio. The asset class provides access to riskier securities than government bonds, but also occupies a higher place in the capital structure should macroeconomic conditions deteriorate. With the global economic environment improving, a close analysis of corporate bonds can yield strategies that offer a yield pick-up versus their vanilla counterparts – even when interest rates are on the up. With market waters more turbulent than they have been for some time, we would encourage investors to look to these safer harbours.