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.
As 2017 comes to a close, it is useful to review where we’ve been, and importantly what we anticipate for the global credit markets in 2018. This has 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 going into 2018 will be important determinants of portfolio positioning.
We believe that valuations across the major credit markets are quite stretched and we close 2017 more defensively positioned than at the beginning of the year. While we believe that economic activity should remain on a solid footing into the new 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 2018 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 in 2018 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 into 2018.
- 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.
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 this year. 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 entering 2018 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.
Other articles in our Outlooks 2018 series are available here.
Important information: This communication is marketing material. The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall. Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors. Issued by Schroder Unit Trusts Limited, 31 Gresham Street, London, EC2V 7QA. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.