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Near-term uncertainty creates opportunities in credit markets
Nicholas Ware, fixed income portfolio manager, provides a fresh update on credit markets, arguing that near-term political and economic uncertainty supports the case for investing in bonds from issuers that offer ‘sensible income’.
13 Sep 2024
1 minute watch
1 minute watch
Key takeaways:
- Corporate bond markets have performed well year to date, helped by the carry (income) that has appealed to investors.
- Uncertainty around the outcome of the US election, together with mixed economic data may lead to near-term widening of credit spreads but expectations are that total return (income and capital gain) are likely to be positive for credit markets for the full year.
- In our view, investors can capture the returns on offer from corporate bonds by investing in ‘sensible income’, i.e. bonds from corporate issuers that are less cyclical, with predictable cash flows and strong financial health.
IMPORTANT INFORMATION
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
There is no guarantee that past trends will continue, or forecasts will be realised. Past performance does not predict future returns. Yields may vary over time and are not guaranteed.
Definitions
Barbell: An investment strategy that advocates investing in a mix of assets with opposing characteristics.
Carry: The benefit or cost of holding an asset, including any interest paid, the cost of financing the investment, and potential gains or losses from currency changes. It can also be used to describe income on a bond.
Cash flow: The net amount of cash and cash equivalents transferred in and out of a company.
Corporate bond: A bond issued by a company. Bonds offer a return to investors in the form of periodic payments and the eventual return of the original money invested at issue on the maturity date.
Credit is typically defined as an agreement between a lender and a borrower. It is often used to describe corporate borrowings, which can take the form of corporate bonds, loans or other fixed income asset classes.
Credit fundamentals: The basic qualitative and quantitative information that reflects the company’s financial and economic position, for example, its earnings, ability to generate cash, management quality and levels of debt.
Credit rating: A score given by a credit rating agency such as S&P Global Ratings, Moody’s and Fitch on the creditworthiness of a borrower. For example, S&P ranks investment grade bonds from the highest AAA down to BBB and high yields bonds from BB through B down to CCC in terms of declining quality and greater risk, i.e. CCC rated borrowers carry a greater risk of default.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing (tightening) indicate improving.
Cyclical: Companies or industries that are highly sensitive to changes in the economy, such that revenues generally are higher in periods of economic prosperity and expansion and are lower in periods of economic downturn and contraction.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Duration: the sensitivity of a bond’s price to a change in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa. Bond prices fall when yields rise and vice versa.
High yield: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings.
Landing: A hard landing is where the economy contracts sharply. A soft landing is a moderate slowdown in the economy in response to a controlled reduction in inflation.
Leverage: Another term for indebtedness e.g., a company with high leverage would have high debt levels relative to earnings.
Maturity: The maturity date of a bond is the date when the principal investment (and any final coupon) is paid to investors. Shorter-dated bonds generally mature within 5 years, medium-term bonds within 5 to 10 years, and longer-dated bonds after 10+ years. the sensitivity of a bond’s price to a change in interest rates.
Sovereign bond: A bond issued by a country, another term for a government bond.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.
Yield: The level of income on a security, typically expressed as a percentage rate. For a bond, at its most simple, this is calculated as the annual coupon payment divided by the current bond price.
Carry: The benefit or cost of holding an asset, including any interest paid, the cost of financing the investment, and potential gains or losses from currency changes. It can also be used to describe income on a bond.
Cash flow: The net amount of cash and cash equivalents transferred in and out of a company.
Corporate bond: A bond issued by a company. Bonds offer a return to investors in the form of periodic payments and the eventual return of the original money invested at issue on the maturity date.
Credit is typically defined as an agreement between a lender and a borrower. It is often used to describe corporate borrowings, which can take the form of corporate bonds, loans or other fixed income asset classes.
Credit fundamentals: The basic qualitative and quantitative information that reflects the company’s financial and economic position, for example, its earnings, ability to generate cash, management quality and levels of debt.
Credit rating: A score given by a credit rating agency such as S&P Global Ratings, Moody’s and Fitch on the creditworthiness of a borrower. For example, S&P ranks investment grade bonds from the highest AAA down to BBB and high yields bonds from BB through B down to CCC in terms of declining quality and greater risk, i.e. CCC rated borrowers carry a greater risk of default.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing (tightening) indicate improving.
Cyclical: Companies or industries that are highly sensitive to changes in the economy, such that revenues generally are higher in periods of economic prosperity and expansion and are lower in periods of economic downturn and contraction.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Duration: the sensitivity of a bond’s price to a change in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa. Bond prices fall when yields rise and vice versa.
High yield: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings.
Landing: A hard landing is where the economy contracts sharply. A soft landing is a moderate slowdown in the economy in response to a controlled reduction in inflation.
Leverage: Another term for indebtedness e.g., a company with high leverage would have high debt levels relative to earnings.
Maturity: The maturity date of a bond is the date when the principal investment (and any final coupon) is paid to investors. Shorter-dated bonds generally mature within 5 years, medium-term bonds within 5 to 10 years, and longer-dated bonds after 10+ years. the sensitivity of a bond’s price to a change in interest rates.
Sovereign bond: A bond issued by a country, another term for a government bond.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.
Yield: The level of income on a security, typically expressed as a percentage rate. For a bond, at its most simple, this is calculated as the annual coupon payment divided by the current bond price.
View transcript
Nicholas Ware: Hi, I want to talk about the credit market to the end of 2024 and what to expect. We know the economies are slowing and you have central banks delivering rate cuts.
It is a healthy environment for credit. I think the market will stay unpredictable and bumpy for a while, so it’s best to hold on to a portfolio that includes sensible income investments.
Credit markets have performed well year to date with the benefit of carry providing a nice return. There have been three economic and political events which caused a sell off during the year, but which quickly reversed as the dip has been bought. So they were in April, Israel-Palestine, June, the French elections and early August, the weak US employment data. The 2024 credit market I can characterise as being a range-bound credit market.
I think the all-in yield proposition despite the sovereign rally since May still holds, albeit spreads look a touch rich.
We are seeing a nice tailwind from fund inflows too as investors want to lock in yields. The first week in September we saw the fifth largest issuance week ever in US investment grade and that was taken down very well by the market.
In terms of outlook?
I think we will see some spread widening for a couple of months till the end of October. The driver likely being US election volatility and the pricing in of some form of hard landing.
But ultimately into year end, I think you’ll still end up with a positive total return with the benefit of carry outweighing any spread widening in both investment grade and high yield.
We passed through the Q2 earnings season, which looked fine and leverage metrics still look robust in both the US and Europe for investment grade, with some weakening in high yield.
We are currently going through the conference season as it is called where companies go to conferences. And there have been some slight deterioration and we are anticipating weakening in companies exposed to low-end consumers and also the consumer staples sector.
But overall, I would say the credit market is in fairly good shape. The driver of this I think are companies in general through this expansion have been cautious. We have seen evidence of this through business surveys, which are showing a worse picture than the actual hard data. And that has been true since this cycle started post the COVID outbreak.
We have seen no build-up of leverage, speculative M&A or over-expansion through this cycle.
I think most of the public credit markets, so the investment grade and high yield market, are coming into the slowdown relatively clean, with no obvious vulnerabilities.
We think buying sensible income, both in investment grade and high yield makes sense here given that backdrop.
Sensible income is a mantra that we use to define us.
We avoid lending money to certain industries because of inherent cyclicality, such as autos and airlines. Plus their inability to generate a good free cash flow return on investment over time
To give an example of a sensible income company. Iron Mountain is one of those quiet bond issuers. It is rated BB-. It is a storage and data centre business, which is listed in the US. It has managed the transition from just being a document storage business, which was in small organic decline, into a combined data storage and document storage business and it has done that very well.
In the analysis, the business risk, the predictability of cash flow, asset protection and overall financial health of the company merit a higher quality rating.
Iron Mountain’s fundamental [strength] is gaining more recognition in the equity market than it is doing from the credit rating agencies.
Like in August, I think the market through to year end will be closely examining clues on whether we’re heading for a soft or a hard landing. I think these periods will cause volatility and present us with opportunities.
Currently, what we like is investment grade in the 3 to 5 year maturity bucket and the 7 to 10 year maturity range as well. And also BB high yield.
We think a barbell of lower duration, sensible credit exposure and taking long duration via sovereign exposure makes sense here, given that market backdrop.
13 Sep 2024
1 minute watch
1 minute watch
Key takeaways:
- Corporate bond markets have performed well year to date, helped by the carry (income) that has appealed to investors.
- Uncertainty around the outcome of the US election, together with mixed economic data may lead to near-term widening of credit spreads but expectations are that total return (income and capital gain) are likely to be positive for credit markets for the full year.
- In our view, investors can capture the returns on offer from corporate bonds by investing in ‘sensible income’, i.e. bonds from corporate issuers that are less cyclical, with predictable cash flows and strong financial health.