Perspective

Why credit can cope with phase of deep uncertainty


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.

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.

Europe is at a disadvantage from an energy price perspective, compared to other parts of the world. 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.

Credit valuations attractive, fundamentals healthy

If we focus 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.

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.

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 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 limit 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.

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

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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