07 May 2018
Invesco Perpetual Corporate Bond Fund Manager Michael Matthews explains why investors must look beyond the negative headlines. There are still plenty of opportunities to make money in credit.
The sharp sell-off in government bonds has spooked investors in recent months.
Since the start of the year, 10-year US Treasury yields have risen from 2.4% to 2.8%, brushing the psychological 3% barrier on 21 February. It has been a similar (albeit less dramatic) story for gilts – with the 10-year yield up 20 basis points year-to-date, trading around 1.4%. The upshot has been a widening of credit spreads and a spill-over of negative sentiment into other asset classes, including equities.
With the volatile first quarter out of the way, there are two schools of thought concerning the direction of travel for markets. The first is that we are late cycle, particularly in the US, and due to see growth slow from here. In this situation, valuations look stretched and credit spreads may widen.
In the second scenario, the global economy continues to grow, creating the potential for inflation to pick up. Against this backdrop, quantitative easing (QE) comes to an end and in some instances quantitative tightening (QT) begins. This is likely to cause interest rates and government bond yields to rise. In the first scenario, investors face the headwind of credit risk, while the second presents them with interest rate risk.
Which scenario do we expect will play out? The Invesco Perpetual Corporate Bond team sits in the second camp, based on our belief that the backdrop is supportive enough for central banks in the UK, Europe and US to tighten policy. This year, we suspect the Federal Reserve will continue to hike, the Bank of England will raise interest rates and the European Central Bank will halt its bond buying programme. Inflation is one of the risks facing the market. For us, it is currently more of an amber warning about the potential risks rather than an expectation of an imminent significant increase. Nonetheless, with economic growth still intact, albeit at a slower pace than previous months and the consensus forecasts for European and US labour markets to continue to tighten, inflation and its consequences for central bank policy, is a risk we are cognisant of.
In the event that government bonds continue to sell off and interest rates in the US and UK rise, the good news is that because of the higher yields on offer there are still opportunities for investors to make money in credit.
If global growth continues, it is hard to see defaults picking up - so we don’t expect credit spreads to widen substantially. In this environment, returns will be driven by the carry you are getting on the yield curve or by taking credit risk where appropriate (where the risk-reward balance pays off), as well as clipping coupons.
It is important to remember that yields in investment grade remain low by historic standards. When yields are low, it is crucial to avoid making mistakes; this means credit selection is key.
Our top-down analysis has guided us towards opportunities in US credit. Treasuries have sold off more than gilts, so we are getting a yield pick-up by taking US duration risk over UK duration risk. In a lot of cases credit spreads in the US are higher than sterling and euro credit markets, as there is less distortion from central bank buying. We have found opportunities across sectors, including large cap telecoms where we own issuers such as Verizon and AT&T. Of course, this is not a free lunch and consideration needs to be given to the foreign currency hedging cost/US dollar risk.
Closer to home, we think subordinated financials still look attractive. It has represented a theme in the portfolio for close to 10 years because the regulatory environment for banks is supportive of credit investors, capital levels are rising and non-performing loans are falling. Nevertheless, selectivity is important. Following a strong year, valuations of these securities have converged with the rest of the market while many of the bonds previously offering attractive yields, such as the legacy tier 1 bank bonds are being called. As a consequence, the opportunities for income are fewer than they used to be. The Barclays 14% Tier 1 bond is totemic of this trend. It was issued during the crisis in 2008 – hence the very chunky coupon. As recently as 2014 it was yielding 6.5% but now, through a combination of the continued improvement in the credit and the lapse of time towards its 2019 call date, it is priced at 112/113 and yields just 2.7% (yield to call).
When these bonds have been called, we haven’t simply replaced them with the new style AT1 contingent capital (CoCo) instruments. They are different instruments with different risks. So ultimately our financials weighting has fallen over time. This has presented us with an opportunity to make the portfolio more defensive by issuer and maturity - and we have tried not to give up too much yield in the process.
Most of the opportunities we are finding are in areas not within corporate bond indices; subordinated bank capital, corporate hybrids and high yield. Because of this their prices often better reflect the risk of the underlying credit and means that they are less vulnerable to central bank’s withdrawing support.
Despite the recent volatility, the demand for yield means that bonds continued to be well received by the market. For example, US pharmacy store, CVS raised $40bn in March 2018 in order to fund the acquisition of health insurer AETNA. This was the third largest corporate issue ever and was significantly oversubscribed. This was not an isolated example with both Sanofi and Telefonica raising substantial sums in then new issue market.
Broadly speaking, valuations continue to receive support from inflows into the investment grade market, driven by demand for yield. Meanwhile, we don’t expect to see significant moves in investment grade yields or credit spreads right now.
When you factor in a supportive economic backdrop, defaults should not become an issue any time soon. In sum, we think it is too early to be bearish on credit. However, given where valuations are right now, it may be too late to be bullish.
There are still opportunities in the investment grade market for investors who are able to clip coupons and avoid taking on too much credit and duration risk. This is certainly our approach with the Invesco Perpetual Corporate Bond Fund.
This post originally appeared on the Invesco Perpetual site.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.
Important information
This email is for Professional Clients only and is not for consumer use.
All data is as at 31.12.2017 and sourced from Invesco Perpetual unless otherwise stated.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
Invesco Perpetual is a business name of Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire, RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority