What are the income opportunities available in credit?
What are the income opportunities available in credit?
Generating returns from income looks set to remain challenging for investors. Government bond yields are expected to remain low for some time given the scale of monetary and fiscal stimulus being implemented across the world. Equity dividends are being cut, as company revenues and earnings decline, or because central banks or governments require this in order to extend certain loan arrangements.
The challenge facing income investors
The chart below shows just how much lower yields on global government bonds and equities are compared to credit markets. Global investment grade now yields 2.8%, versus 0.4% on government bonds, 2.7% on the Euro Stoxx 500 and 2% for the S&P 500, while global high yield (HY), which is the riskier end of corporate bonds, yields more than 8% in aggregate.
This gap may also be set to widen with equity dividend futures in the US and Europe currently predicting dividends will decline by between 25% and 50%.
With little income on offer in the government bond or equity markets, it seems inevitable investors will increasingly look to the credit market for opportunities. We believe there’s currently a window of opportunity for investors given historically high corporate bond spreads, which underlines the attractiveness of yields in credit compared to other markets. A corporate bond spread reflects the excess yield over a lower risk, similar maturity government bond, so a higher spread implies better value.
Spreads likely to “normalise” before year-end
The below charts illustrate how wide credit spreads are at the moment. The sharpness in their rise over the lasts six weeks is unprecedented and shows just how severe a recession the market is pricing in.
These levels are also unsustainable, or at least they have been in the past, as the charts also demonstrate. While there is likely to be more stress ahead of us (so we could see further sharp moves up or down in spreads), we also believe these exceptionally elevated levels will likely only last up to two quarters before returning to more normalised levels. Ultimately, this move will likely be driven by a change in sentiment and could well be quite rapid.
As well as the potential for income returns, there is also the added element of potential price appreciation, since bond prices rise as yields and spreads fall. Historically, from the current spread levels on US dollar investment grade (IG) bonds, which are regarded as lower risk and higher quality, of 200 basis points (bps), the excess return over government bonds in the proceeding three years has averaged about 9% annualised. For US dollar high yield (HY), the current spread of between 700-800bps, has been followed by annual excess returns of 18% over three years, and 30% over five years.
What about defaults?
While the return prospects are attractive, there is nevertheless the likelihood that defaults will rise given the stress in the market. This increased and very real risk is part of the reason yields have risen so much. We believe, however, that the rate of defaults implied by market levels has gone too far.
The historical average five-year default rate for global IG has been 0.9%; based on the current level of spreads, US IG now has an implied default rate of 8.7%. For the HY market, the historic average default rate is 14.6% compared to a currently implied 37%.
Which areas look attractive?
While we expect a decline in global GDP by 3%, there will still be winners in this crisis situation. Retailers with convenience store footprints, for example, are seeing increased demand as social distancing in many countries preventing people from eating out in restaurants and travelling far for their groceries.
The importance of telecommunication services has increased significantly. With the rising number of people working from home, demand for broadband services has risen and we’ve seen a number of telecommunication businesses become more profitable. As individuals and households are unlikely to change broadband providers, telecoms providers have seen a reduction in marketing costs and less customer “churn”.
One might expect reduced power demand from the industrial sector to have a negative impact on utility companies, but power demand from the private and residential sector, which pay higher prices, is up. Also, power companies’ revenues are no longer solely linked to power volumes; they are also linked to service contracts. So for the most part, we expect revenues for utilities will be relatively stable.
Then there are the more vulnerable companies who have had to effectively hibernate, in some cases halving or virtually wiping out revenues. There are numerous companies within the leisure, hotels, airlines and transportation sectors struggling to cover their operating costs. As these companies start to run out of liquidity they will have to turn to central banks, government programmes or the financial markets. We have seen some instances already of businesses in these areas, some of high quality, with strong underlying operations and sizable assets, issuing new bonds with very attractive yields.
Window of opportunity
The income opportunity set in global credit has expanded significantly over the past few weeks. Credit spreads are at historic highs, offering yields that neither the equity market nor the government bond market can match. In the past, these levels have preceded attractive returns, but we think investors probably have a relatively short window of opportunity to take advantage of these dislocations in the market.
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