Fundamentally, there are a lot of good reasons to support credit in the US. GDP growth is at – or potentially above – trend, earnings are continuing to be strong at corporate level and balance sheet health remains in good shape.
However, there are some issues on the valuation side, particularly in sectors where the line is being crossed in terms of what is good for credit versus what is good for equities. Areas such as energy and communications are examples of sectors doing more to benefit shareholders at the expense of bondholders. These are actions such as heavily debt-funded M&A, increased levels of growth capital expenditure, as well as special dividends.
Across both investment grade and high yield in the US, the most important aspect at the moment is to manage interest rate risk appropriately – given the potential effects of Federal Reserve tapering.
Many people suggest the best way to mitigate interest rate risk is by either moving into short duration, or by moving lower down the credit risk spectrum. This can be too narrow an approach. In an already illiquid market, it compounds the issue of crowded trades and concentration of positions. Credit curves are near decade steepness and the pick-up in spread to go from BB to CCC is at pre-crisis lows. This is not the time to go with the herd.
Instead, investors can take on ‘up in quality’ trades – favouring BBs in high yield versus the lower end – while also favouring the long end of the credit curve versus the short end.
This positioning is against the growing market consensus. It obviously leaves you with the potential for more interest rate risk, because this part of the market is more exposed. This can be mitigated by either buying the bond and hedging with futures – or sell CDS instead of buying a bond, which incurs no interest rate risk.
Europe, particularly in southern areas, is the opposite of the US in some ways, with corporates still behaving with bondholders in mind. Instead of focusing on near-term share price aspects such as M&A, corporates are trying to retrench balance sheets, term out debt maturity profiles and prioritise credit ratings.
However, much of this is now priced in given the outperformance of Europe versus the US over the past 18 months. Many of the strong fundamental reasons to favour Europe are already displayed in the price.
There are still pockets of good value, such as recent German issuer Lowen. The company benefits from low leverage, good free cash flow generation and consistently high margins. In addition, the recent deal was structured to ensure bondholders are attractively compensated should the company perform, avoiding a lot of the shareholder friendly ‘leakage’ that has become prevalent in other areas of the high yield market.
There is value on the cusps of emerging markets, particularly in higher quality countries and corporates. These are global business operations, with large capital structures. As many of these companies are exporters, they are benefiting from emerging market currency weakness.
