Outlook 2018

Outlook 2018: Global corporate bonds

Global corporate bond valuations are elevated and insufficient to compensate for risk, but there will continue to be selective opportunities to take high conviction positions.

11/01/2018

Rick Rezek

Rick Rezek

Global Credit Fund Manager, Fixed Income

As 2017 came to a close, it is useful to review where we’ve been, and importantly what we anticipate for the global credit markets this year. 2017 had been another strong year for credit with excess returns for each of the major markets in strongly positive territory. The credit markets have been driven, in our opinion, by two central themes.

For the first time since the credit crisis a decade ago, we are seeing synchronised growth in economic activity from most of the major developed market economies. This, coupled with recoveries in certain emerging markets, has underpinned a solid pick-up in corporate revenues and earnings across regions.

Second, ongoing extraordinary monetary policy from certain central banks has continued to suppress government and corporate bond yields which have pushed investors to take more risk within their fixed income portfolios. Assessing the viability of these two factors this year will be important determinants of portfolio positioning.

We believe that valuations across the major credit markets are quite stretched and we closed 2017 more defensively positioned than at the beginning of the year. While we believe that economic activity should remain on a solid footing this year, we believe the margin for error reflected in current valuations warrants a great deal of caution. In addition, we believe the era of extraordinary monetary policy is slowly coming to an end.

In the US, the Federal Reserve has ceased reinvesting the proceeds earned from maturing bonds, purchased under the quantitative easing programme, and interest payments from the bonds it continues to hold. This removes a source of demand from the market. We expect Treasury yields to normalise over the course of the year.

In Europe, the European Central Bank (ECB) has begun to slowly cut back on its purchases of corporate bonds. This process will almost certainly continue through this year which will remove the largest buyer of investment grade corporate bonds in the eurozone.

As such, we expect credit spreads (the difference between corporate and government bond yields) to be at best unchanged this year and likely moderately wider in major credit markets.

Key drivers of corporate bond markets in 2018

  • While inflation has been surprisingly subdued given economic growth, we are watching closely for any uptick which could result in more aggressive monetary normalisation from central banks.
  • Global macroeconomic activity appears to be as strong as it has been since the credit crisis. Continued economic strength is one factor that needs to be maintained if spreads are to remain stable or narrow from current levels.
  • The pace of “quantitative tightening” and the market's reaction will be an important factor not only for credit markets but likely for equity markets also.
  • The pending tax legislation in the US may have a significant impact on corporate capital structures, the supply of new debt to be issued, and on economic activity in the near term. We will closely monitor the provisions in the final legislation in an effort to assess market impact this year.
  • Brexit: The direction and economic impact on both the UK and EU remain uncertain. A disorderly exit could present both economies with strong headwinds at least in the short term.
  • Geopolitical risks remain heightened. Predicting geopolitical events seems to us a fool’s errand. However, we assess the range and likelihood of these events and make a determination whether we are being adequately compensated for these risks.
  • Valuations are, to be blunt, unattractive. In our opinion, a great deal of positive news has been priced into the market. We do not believe we are being appropriately compensated at current valuations.

Positioning

In the last couple of years, positive sentiment, extraordinarily accommodative monetary policy and a favourable supply/demand dynamic has pushed valuations to multi-year highs. That dynamic could be near a turning point. While we view credit risk broadly as undercompensated, the opportunity to deliver good returns through careful sector and security selection remains intact.

Correlation (the extent to which two securities move together) of returns among sectors and issuers has been trending downward since the second quarter of 2017. If exploited diligently, this can bear fruits for active managers. With that in mind, there are still opportunities to take high conviction active positions.

The banking sector continues to look attractive as we see potential for the regulatory burden to be somewhat diminished by the Republican administration in the US while capital levels remain strong.

The energy sector too exhibits good fundamentals based on continued deleveraging and valuations. Emerging market sovereign debt could be negatively impacted by a strong dollar especially countries where valuations appear full.

High yield corporate bonds valuations have become quite elevated in 2017, but there are still areas of the market worth holding, generally in more defensive sectors offering attractive yield relative to investment grade bonds.

Triple-B rated corporate bonds remain attractive. We believe that, within the investment grade universe, these continue to offer the best compensation for risk taken. Additionally, in the US, measures of leverage (amount of balance sheet debt) of BBB-rated credits have actually shown more stability than those of higher rated credits.

Defensive positioning will likely be the most prudent approach this year and will remain so unless valuations move to more attractive levels. We see scope to opportunistically take advantage of dislocations at the market, sector or security level. We do not believe now is a time to reach for yield in an effort to boost short-term performance.

 

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