While the past two years were important in terms of central bank policy and the yield curve impact, we think Asian investors should focus on the broader global picture. Following 10 years of extraordinary monetary policy, central bank balance sheets have become bloated.
This has had a profound impact on financial markets, to the extent that over 25% of global fixed income assets now trade at negative yields [JP Morgan Insights, “Why are bond yields going negative again?” April 5 2019]. In a persistent low interest rate environment, questions are now being asked of the predictability of returns for traditional fixed income asset classes.
Accommodative central bank policy has helped boost global economies; however, this impact is starting to fade. Economists and markets now expect GDP and inflation growth to slow, then stabilize at these levels in the coming years. We believe this environment is attractive for sub-investment-grade markets as it allows leveraged companies to service their debts and sustain their capital structures.
It is periods of higher growth, more suited to equity markets, that can lead to behaviour that is detrimental to creditors, i.e., larger dividends.
The appeal of sub-investment grade
While we are attentive to the impact of lower expected growth, we do not see an imminent end to the credit cycle. Corporate fundamentals in the United States and Europe are firm. Earnings are positive, leverage is stable, and global central banks have renewed their accommodative rhetoric. We expect default rates, which are still near historic lows, to pick up. However, we do not see a trigger for a spike anytime soon that would warrant repricing spreads at materially higher levels.
Against this backdrop, we believe investors will continue to allocate to sub-investment grade markets given the underlying fundamentals and attractive yield advantage. These markets also have exhibited low relative volatility over time, resulting in strong risk-adjusted returns.
In fact, certain sub-investment grade markets’ long-term volatility is more aligned with traditionally stable fixed income asset classes, while offering higher yields and minimal duration.While this risk/return relationship is a backward looking measure, we believe it will hold going forward.
Sub-investment grade credit consists of a number of different but increasingly interconnected markets, including US and European senior secured loans and high yield bonds, as well as alternatives such as structured credit, and stressed and distressed credit. Relative value moves quickly favouring these markets at different times.
We believe that experienced managers actively dealing in these markets on a daily basis are best placed to allocate efficiently across markets, regions and sectors as risks and opportunities shift, especially using an integrated, holistic portfolio construction process.
Traditionally, institutional investors approached liquid assets as individual allocations within their portfolios. Within this strategy, many asset allocators made decisions based on top-down views. Capital was then passed to specialist managers to manage on a siloed basis. However, markets have evolved, previously standalone pools of assets are becoming increasingly interconnected. Consequently, some companies now issue debt in more than one of these markets, and in some cases all four, e.g., Virgin Media and INEOS.
While this approach may be well established, it does have drawbacks. It gives limited consideration of relative value between markets. As a result, an investor can end up with over-diversified portfolios, as well as outsized holdings in single issuers and sectors. For example, it is conceivable that an investor could build an unintended exposure to a single issuer in all four asset classes with little consideration for relative value between them.
A multi-asset credit approach allows a single portfolio manager to focus on dynamically allocating across markets, while optimizing the portfolio by choosing the best risk-adjusted return opportunities regardless of markets and within an integrated risk management construct.
The effectiveness of this approach is particularly evident during periods of heightened volatility. In December, for example, US senior secured loans and high yield bonds underperformed relative to European markets on concerns of a monetary policy misstep, including cross-currency issues of the same capital structure.
As the Federal Reserve’s rhetoric changed, markets recovered quickly in January. A multi-asset credit approach, which is nimble and outcome-focused, can deliver holistic exposure to liquid and alternative assets.
Vijay Rajguru is chief investment officer of Alcentra