It’s great to see some volatility back in the market. What had been shaping up to be a pretty uneventful year, with falling rates and tightening credit spreads, is finally turning into one that offers investors some real opportunities – in areas such as U.S. and European high yield, European bank capital notes, and selected emerging market bonds.
But as portfolio managers, we are very careful. What people called the Big Beta Trade – a general cheapness in the market and the big tailwind provided by low rates – has largely faded, and now it comes down to security selection. Given the limited liquidity in the market these days, you have to be an investor again, not a trader. We have to do our research and have conviction behind the securities and strategies that we put in portfolios and we have to be willing to live through a bit of volatility.
Yields are already priced for some medium term backup over the next year. But, despite recent economic strength in the U.S., we expect the U.S. Federal Reserve (Fed) to be patient and cautious in the normalization process. The Fed will be cognizant of any pressure that rising rates puts on the economy and is also mindful of the very low inflation environment that currently exists. Outside of the U.S., many central banks are still highly accommodative or are easing. Any adverse market reaction to the Fed raising rates should be offset to some extent by the increased easing coming out of the European Central Bank (ECB), the Bank of Japan (BOJ), and the People’s Bank of China (PBOC). In addition, credit fundamentals look excellent and default rates are quite low.
Our work suggests we are somewhere around 60-65% of the way through the current credit cycle. Typically, post recovery, the credit bubble bursts about one to 1 1/2 years after the end of the tightening process. So if the Fed is not even starting until 2015, you’re looking at 3 or 3 ½ years before you have to be concerned about Fed policy going from accommodative to pernicious.
The U.S. high yield market is one of the opportunities that volatility has created. Yields have backed up and credit spreads have widened. A 4.5% credit spread is very generous compensation for credit risk, in an environment where defaults are running 1%. And high yield passes the ‘sniff test’ as well. Companies have run conservative balance sheets, and they’re being careful in what they spend. For us, as lenders of our clients’ money, it’s a great time to be a lender, and the last couple of months have created some good value.
European high yield also looks good. Macro policy has been extremely supportive. If you’re a European company or bank, the message you’ve heard is that you’re not allowed to fail. Default rates are even lower in Europe than in the U.S., as the focus has been on deleveraging; companies are running prudent balance sheets and using revenue to reduce debt. While you get a slightly lower yield in Europe than you get in the U.S. high yield market, you get equally strong fundamentals and the added benefit of the wind at your back that results from all of the stimulative action coming out of the ECB.
While the emerging markets have always looked a little over-bought to us, recent volatility and spread widening has also created selective opportunities. We look at some sovereign external debt and it’s cheapened up a bit. We’re looking at Eastern European countries that have solid current account balances, that have manufacturing based economies, and that may benefit from the stimulus that’s coming out of the ECB. We’re not so keen if the economy is slowing, and we’re cautious of commodity-oriented sovereigns. We like sovereigns that offer very high real yields and the potential for central bank easing. At the local level, we’re seeing a backup in yields and some correction in the currencies, but we’re also seeing growth and inflation falling, which should be good for local bond markets.
The best returns over the coming year are going to be for managers who are invested, who have yield in the portfolio and some carry. The party won’t end until the Fed takes the punch bowl away, and they haven’t even started yet.