Credit Markets Still Offer Pockets of Value
MANAGER Q&A: Liontrust Asset Management's Head of Fixed Income points investors to areas of value in the credit market
Holly Cook: If, indeed, we are in a bond bubble at present, when do you see it popping?
Simon Thorp: We do not view fixed income markets as a bubble. Clearly the better quality government bond markets yield very little but real yields are high from a historic standpoint. Also, investors are very well aware of the dangers of such low yields and very few are piling into government bonds in the hope of making large gains (as happens in most bubbles). Credit markets are fairly--and in some cases cheaply--valued. Corporates are in good shape from a credit metrics vantage point and spreads are at levels seen in 2002, when we had double-digit default rates (compared with 2%-3% today). Leverage (debt versus earnings) is coming down to the average of levels seen over the last 20 years. Fixed income markets could sell off sharply if growth/inflation expectations suddenly rise strongly, but that doesn’t make it a bubble in our view.
Cook: With yields so low, where are you finding value within fixed income?
Thorp: We see value in financials. Many non-bank financials trade at cheap levels purely by association with banks, and certain credit instruments within capital structures are cheap--the market is not efficient enough to price all correctly. Commerzbank, for example, has 53,766 bonds! We also see value in some of the better quality senior secured deals that have come to the European high yield market in the last year, however it is crucial to understand the quality of the security package. We also see value in some emerging market credits where similar companies in Europe and the US trade on significantly lower yields and tighter spreads. Finally, there are some short-dated opportunities (1-3 years) in companies with strong liquidity positions where investors in our opinion are being over-compensated for the risk
Cook: How do you see fiscal and monetary policy impacting the fixed income investing outlook?
Thorp: Fiscal policy is likely to have less of an effect than monetary policy. Fiscal policies are likely to remain a drag on growth as sovereigns look to rebuild their balance sheets at a time of massive private sector deleveraging. This dynamic is, we believe, well priced currently in risk markets. Clearly, a meaningful change (much tighter or more lax) in fiscal policies would have a corresponding knock-on effect to credit markets.
Monetary policy remains key. Credit is the beneficiary of investors’ search for yield as money markets and government bond markets return so little. If this were to change, we would see a spike in yield and capital destruction in fixed income assets. Anticipating the start of the tightening cycle in developed economies is critical for performance over the next few years. Bear in mind that many investors started shorting Japanese Government Bonds in the early 1990s with 5-year yields of 2.5%. Today 5-year JGBs yield 26bps!
