Why credit can cope with phases of deep uncertainty
Corporate bond yields have become more appealing and sectors benefiting from in-built resilience to inflation look well placed.
With bond markets already in some turmoil over increasingly hawkish central banks and persistently high inflationary pressure, they are also now contending with a major geopolitical crisis and the fallout from a brutal war.
Where the maelstrom of Russia’s invasion of Ukraine and the West’s response ultimately leads is highly uncertain. We know it is already imposing a terrible human cost. Beyond this there will be many implications for the regional and world political order, which can only become more apparent over time.
As credit investors, our job is to stay level-headed and focus on asset class fundamentals and the companies we invest in. From this perspective we are bound to make decisions on how to position in light of the potential for disruption to markets.
Bonds under stress
For bond markets, the conflict in Ukraine adds to what was already significant pressure. Government yields rose sharply earlier in the year, pricing aggressive interest rate tightening on the back of more “hawkish” central bank rhetoric. European yields have reversed earlier move considerably in recent days, but remain higher than at the start of the year.
Credit markets suffered outflows with spreads widening in recent weeks. This was relatively orderly for the most part, with the market attempting to stabilise on positive earnings announcements, and emerging market bond volatility remaining contained.
But rising yields and spreads have resulted in materially negative year-to-date total returns. Europe in particular was caught off-guard as the European Central Bank (ECB) announced plans to end asset purchases in Q3, “shortly before” raising rates.
With the geopolitical escalation, sentiment veered momentarily toward panic territory, although this had occurred even prior to the actual invasion. Not surprisingly, European credit markets have reacted more strongly than the US to “price in” the risks around the war in Ukraine.
How do we see the macro situation?
Macro level events are very uncertain and are changing quickly. We cannot make predictions on the course of the Ukraine conflict. We are, though, starting to develop a picture of the extent of the risks to the European economy and potential implications for monetary policy.
The risks related to Europe’s reliance on Russian energy is starkly apparent now and evident in European market underperformance. The length of the war and implications for energy prices will be a key determinant for European growth. Here and now, it is a question of how high energy prices go.
There is a pressing need for securing European energy supplies away from Russia. This looks difficult in the short-term, since it is neither easy to import from other countries or to quickly reduce use of fossil fuels, the long-term goal.
Europe is at a disadvantage from an energy price perspective, compared to other parts of the world. The UK does not import much from Russia, while the US economy is pretty self-sufficient. The main implication is increased risk of stagflation for Europe. There are expectations that there will be fiscal help within Europe for consumers and corporates to fend off the energy shock.
In terms of monetary policy, the market’s expectations for rate hikes for 2022 were six in the US and one in Europe. This looked high and has started to moderate. The crisis, economic shock and the deleterious effect on confidence could prompt central banks to temper rate rises. It increases the likelihood of fiscal support. This would likely be targeted toward alleviating the impact of higher energy and food costs for consumers.
Clearly valuations are reflecting low growth and risk of recession within Europe but the length of the war and the nature of fiscal support will be key here. Inflation is also going to rise, so the balancing act facing central banks is even trickier.
Credit valuations attractive, fundamentals healthy
If we focus in on credit valuations we find levels are now more appealing, with yields now at attractive outright levels, and even offering better income prospects than equities. The difference between the Euro Stoxx 600 gross dividend yield and euro investment grade (IG) yield is the narrowest in nearly a decade, at just over 1.0% at the time of writing. Corporate hybrid bonds (such as perpetual bonds which have no fixed maturity date) are yielding the same as equities.
For euro high yield (which is lower grade credit), a yield premium of 2% is the highest since early-2016, excluding March 2020. In the US, an IG credit yield of 3.2% compares more favourably to the S&P 500 dividend yield of 1.9%.
Credit can also act as a diversifier should growth falter more than expected. Income affords a cushion, while higher grade corporate bonds are less sensitive to growth than stocks. These factors should make credit attractive to a wider, non-specialist investor base, potentially spurring institutional investors or multi-asset funds to increase allocations.
There are still signs of decent activity in the underlying economies of Europe and particularly the US and China has begun monetary easing. This is helpful to corporate fundamentals, supporting earnings which are at record levels. Balance sheets are decidedly healthy too, with companies having refinanced at low levels of interest last year. For euro IG, interest coverage (EBITDA to interest expenses) is over 10 times. Market levels are implying a higher rate of defaults than is likely to materialise based on fundamentals.
At the same time, there is a growing need to be selective. Companies face rising input cost pressures, which may potentially worsen should energy prices rise further, and we are starting to see this impact revenues.
Which sectors are well placed?
We are think sectors with some in-built defensive characteristics, such as inflation protection and strong asset-backing are well placed.
In real estate for instance, many companies have rents linked to inflation over the medium-term and we see logistics and residential companies benefitting from still strong demand. Covenants in bond documents limits leverage in the sector and companies benefit from well diversified property portfolios. Currently, some property company bonds have yields higher than on the underlying property assets. This situation should correct and offers value to bond investors.
A similar example is infrastructure, namely operators of assets such as toll roads and telecom towers which in many cases have revenues linked to consumer price inflation.
Most of the assets are in operation and maintenance capex is relatively low, so cash flows are predictable. A potential recovery in tourism in parts of Europe this summer, with lockdowns having eased, and the rollout of 5G means provide additional revenues for these sectors. These bonds have been under pressure.
The energy sector is seeing a large revenue and earnings boost from higher oil, gas and power prices. We see a good long-term case for integrated energy companies with plans for transitioning to a low carbon and net zero future. Despite record earnings and low leverage, energy sector bonds have experienced sharp price falls, in a number of cases unjustifiably given fundamentals.
In Asia, market dislocation from geopolitical tension would offer attractive opportunities, particularly in the Indian renewable energy sector, where ample demand will continue to support fundamentals.
Credit can stabilise
Alongside the human tragedy of the current situation, this is a moment of great uncertainty on account of numerous, rapidly changing factors.
Given still overall favourable growth and strong company fundamentals we think there is scope for credit to stabilise and start to perform better in time. We retain our conviction in strong sectors and companies, with the characteristics to weather challenging circumstances, looking for opportunities where we find valuations disconnected from fundamentals.
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