It is hyperbolic to suggest that bonds face a nuclear explosion but in reflecting on the uncertainty that surrounds markets and politics I was drawn to the protection advice offered throughout the 1950s and 60s. Understandably investors are aware that risks to the downside outweigh those to the upside and are looking for places to find cover.
It is worth quickly recapping on where we are. Even before President Trump was elected, a reflationary trade had taken hold. His appointment has turbo-charged already buoyant investors who now firmly believe he will deliver growth to the US economy. Having hiked once already, the consensus view is that the US Federal Reserve (Fed) will raise interest rates three times this year, and while we will almost certainly not see a return to pre-crisis levels of around 5%, the trend is clearly upward. US Treasury yields will follow the same trend. As a small aside, I expect the Fed to raise 3.5 times this year, with half a hike (0.25%) coming from the upward removal of its current range-based rate. Taking away the range could be seen as a soft way of tightening policy, and one they utilised in reverse on the way down. Working against this optimism is the spectre of protectionism and a strengthening dollar. For now though, at least, the market mood is cheery, and that spells bad news for bond investors.
Consequently we have been reducing risk, but not in the usual way. Government bonds are fine for reducing default risk, but because of the length of maturity required to earn any meaningful yield they do little to reduce duration risk – i.e. the overall sensitivity of a portfolio to interest rate rises. Corporate bond markets are far more useful for addressing this. But even there we are cautious of what lies ahead.
Politics is destined to dominate thoughts, debates and investment markets.
Politics, it seems, is destined to dominate thoughts, debates and investment markets – impending elections across Europe are being keenly watched for any signs of populist success. To this end, we have positioned our portfolio to favour a long position in the US, using credit default swap indices, over the European equivalent (betting that the US credit market will outperform Europe). It is a straightforward pair trade that reflects both the political risk emanating from Europe and the better quality, value and depth on offer in the US investment-grade market.
However, technical factors will still play a role in driving prices. And with central bank bond buying programmes due to end in Europe and the UK, the demand side of the equation will begin to look worrying. In the five months to 22 February, the Bank of England bought £7.4 billion of corporate bonds; in Europe, the European Central Bank (ECB) has bought €67 billion since starting its corporate sector purchasing programme in June 2016 – according to data from each central bank. As these schemes wind down, April for the Bank of England and towards the end of the year for the ECB, it will pay to be cautious – after all, large buyers will be exiting stage left.
The bond market rally has endured for so long that many credit investors have become complacent. This is dangerous, particularly given how many industries are going through upheaval.
One way of controlling some risks is by lending to companies who are heavily restricted in their decision making, either by regulation or by industry dynamics. Utilities and airports are good examples of the former, whereas oil & gas, having already been through a consolidation and cost cutting phase, is an example of the latter. Securitised assets – whether mortgages, properties or whole businesses like pubs – are another way of reducing risk as lenders are higher up the capital structure and management are restricted on what can happen to the assets.
Merger and acquisition activity is something to watch closely. It has profound effects on the attractiveness of corporate bonds.
Merger and acquisition activity is something to watch closely. It has profound effects on the attractiveness of corporate bonds as in order to conclude the deal, the acquiring company will often leverage up using debt. This is fine if company management and economic conditions stick to the script. Leverage rises, only to fall back once cost synergies have been taken out of the joint entity. Yields rise temporarily to reflect this and then fall back down. The theory is clean and predictable – and priced in; the reality is usually messy. The deal can fall through, can be executed poorly by management, or economic conditions can conspire against profits and keep leverage high. Worse still, company management can be tempted into new, not-to-be-missed opportunities before debt levels have been brought into line. Judging management’s form and track record in such cases is essential and a core part of our approach.
Accordingly, media and telecommunications is a sector to be wary of. Vertical integration and consolidation of infrastructure, content production and its distribution has been a key trend. As a result, we have zero exposure to Vodafone (currently reported to be considering a merger deal with Liberty Global’s Virgin Media), and have significantly reduced exposure to AT&T given its respective takeover bid for Time Warner. Meanwhile, Verizon seems likely to make an acquisition in the cable space – perhaps Comcast in the foreseeable future.
Uncertainty is not going away. We have always had to live with it, but staying ahead of markets seems harder than ever. That is why we are running toward less traditional bunkers to find cover.