Credit where credit’s due
For European investors, much of the first half to the year was rather uplifting in terms of investment performance. However, as ever, in today’s market, it never pays to be complacent. Bouts of volatility are never too far away, and one arrived in May courtesy of Ben Bernanke, the Governor of the US Federal Reserve. In a statement he suggested that the central bank would begin to slow down (or ‘taper’) its asset purchase program should the US economy continue to recover. This highlighted that investors can’t rely on interest rates being at record lows forever.
In the aftermath of Bernanke’s comments, investors the world over entered a state of near-panic. June became the sixth-worst month on record for European credit, while Sterling credit posted its second-worst quarter since 1997.
“Core government bond yields are at multi-year lows. Over the long-term, the only direction they can move is up.”
Although markets have largely recovered since, such volatility highlights the dangers out there for prudent investors. How can they successfully navigate these bumpy markets?
Focus on being adequately rewarded for your risks
We believe that in many ways, the simple answer is to make sure that, as an investor, you are being adequately, or more-than-adequately compensated for the risks you are taking. Looking specifically at European corporate bond markets, do they tend to offer attractive returns for the risks?
The short answer is: in one sense they do, but in another sense they don’t. Core government bond yields are at multi-year lows, as shown by the graph below. Over the long-term, the only direction they can move is up. This leaves fixed rate bonds vulnerable to ‘duration’ (or interest rate) risks.
“European corporates have generally looked after their balance sheets over the last decade, and so, in our view credit risks are not substantial.”
However, the second graph shows that, while yields are low, credit spreads are historically rather wide, and therefore attractive considering the risks. They may not be as wide as they were during 2008 or 2011, but they are wide nonetheless. This means that investors are demanding higher returns for taking on credit risks. But should they? European corporates have generally looked after their balance sheets over the last decade, and so, in our view credit risks are not substantial.
So duration risk is not attractive, but credit risks might be. Of course, for a number of institutional investors, duration risk isn’t a problem, since if interest rates sharply rise; the value of their liabilities will fall in line with their corporate bonds (as they will be discounted at a higher interest rate).
But for investors less inclined to accept interest rate risk, they can eliminate it by buying floating rate bonds or hedging their fixed rate portfolios. This will leave them exposed only to credit risks (which look attractive).
“If certain risks are simply not justified, they should be avoided or hedged in favour of risks that are.”
For several years now, hedging out interest rate risks and only taking on credit risk has been a key approach of our non-benchmarked total return multi-asset credit portfolios. This involves investing across a number of fixed income asset classes, from corporate bonds to real estate debt to infrastructure loans. To highlight just one asset class, we’ll take a quick look at the benefits of European leveraged loans:
European leveraged loans – senior, secure and floating rate
Loans are senior, secured assets paying a floating rate of interest. Their floating rate nature makes them essentially immune to rising interest rates. They also offer relatively attractive credit risks thanks to their seniority and security. Recovery rates on defaulted loans tend to be around 70% (compared to 40% for unsecured corporate bonds).
Loans are significantly more attractive today than before the financial crisis. This is because the events of the crisis essentially removed a number of leveraged investors from the market, leaving credit spreads higher. What’s more, we believe that these higher spreads are here to stay, because for a number of reasons, those leveraged investors are unlikely to return. Today, loans yield around 4% above cash rates, compared to around 2.5% before the crisis.
Rational investors must be careful to always make sure that they are being compensated for the risks they are taking. If certain risks are simply not justified, they should be avoided or hedged in favour of risks that are. As today’s yields are low, it can be tempting to look for higher yields through higher risks, but this is a dangerous strategy that can leave investors suffering during bouts of market panic (such as the one markets suffered in May and June this year). In many cases, it’s best to be patient, keep your powder dry, and when there’s a good opportunity to earn attractive returns for the risks – pull the trigger.