Please note: AI generated transcript.
Text on screen: Global credit outlook. Adam Whiteley, Head of Global Credit
And on the chart here we can see that spreads are close to 20 year lows. And whilst we can justify that in our central case, there's no margin for error. And at leads to our directional view on credit to be very close to home.
But if we change our frame of reference and look on the right hand chart here and look at yields whilst they've fallen, they're still very close to 20 year highs. And that leads to a question we're getting a lot from clients. Spreads low yields are high, what to do? And in our view, there are two key answers to that question.
The first is keep it simple. Stay invested, capture the income, shorten duration, build resilience. On the left hand chart, we're showing investment grade yields. And where the dark green area is, the sub five year component, you can capture 90% of the income, but with less than half the volatility.
And whilst it's fair to say that a lot of the heavy lifting there on yield has been done by the government yield curve on the right hand chart, if we look at credit spread curves, they're very flat. You're barely getting any extra compensation for lending for three years compared to 30 years. In fact, it's about 30 basis points. And that makes no sense because the visibility over the next three years and our ability to forecast is much greater than it is over 30 years. And that's even more relevant in the markets like high yield where the default rates are very real.
What's the second answer? To improve resiliency? It's to add flexibility. Why is that relevant? Not all risk Premier are priced equally within credits. There are six different types of risk premium. We've got systemic risk premier, that's investment grade, subordination risk premier, that's the capital instruments issued by investment grade companies. Default risk premier, that's high yields. Country risk premiers, emerging markets and complexity risk premiers asset backed that Shahir will expand on later.
And what we can see from the chart here is that it's the investment grade risk premiums that are most expensive. Here we're looking at on the horizontal axis, a percentile using 10 years of history. The vertical axis is our measure of the current level. So whether it's systemic or subordination, IG risk factors most expensive, there's much better value in country risk, premium and complexity risk premium.
And for em, it's about tailwinds. Em we think can outperform because of the good growth environment. A weaker dollar as Francesca touched on, but also the drive to diversify against US assets for complexity. Risk premium for asset backed is about not having headwinds, not having to worry about being exposed to political risks, not having to worry about lingering concerns on the health of the corporate sector.
The sixth of premium's illiquidity. And that's where private credit plays a role. And we can see on the left hand chart here that that's been getting compressed to over the last 10 years. And whilst that's still very much worth owning as an investor at these levels, you need to be very specific around which assets and which managers you select.
But what we saw last year is that the equity market is beginning to sniff out if there's a problem within private credit and we're showing on the uh, the right hand chart here, share prices of the BDCs or the business development companies versus the broader US market. And something changed. The equity market is concerned about these BDCs who are companies that extend private credits to small and medium enterprises.
And you actually market's concerned for two reasons. If you've got lower rates, lower spreads, that means lower dividend income. But there's also a concern over the quality of the underlying borrowers because of some of the headlines that you will have seen last year.
And if the equity market's right then where should we be looking if these risks are becoming more systemic? The obvious place to start is the insurance sector where the chart here is showing for the US insurers at a system level, their allocation to private bonds, which is now nearly half of their overall bond allocation.
I should caveat that that's not just high yield private credit, that's private IG private asset back two, but over the periods of the last 12 months, the equity market's also become concerned and is pricing in risks around that concentration?
Is the equity market right to be concerned? Probably not. If we look at the chart on the right here, we can look at defaults for direct lending as well as the loan market. And you can see that they've been stabilizing. And in that central case, whilst there are risks around it, the central case of stable growth, lower rates, default rates are probably not gonna see any upward pressure. And this is creating security selection and sector strategy opportunities for us in the bonds that are being issued by the BDCs as well as the insurers.
The story for tomorrow may well be is AI a bubble. The story for today is the enormous CapEx that's being spent to enable the AI revolution. Something that Adrian touched on earlier and on forward looking projections. This is expected to be nearly 2% per annum of US GDP. That's providing an enormous tailwind for growth, but it's not obvious. It's boosting the labor market. And that's coming back to that unstable equilibrium which markets for the time being are happy to ignore.
Last year AI came to the credit market. We had an explosion of issuance from the big companies undertaking this CapEx to help their funding needs. And what that's done is remove the rarity value from these companies that used to be very sporadic issuers creating security selection opportunities.
The numbers we're talking about here are enormous. Yeah, we can all make assumptions around what the CapEx will be over the next five years. We are penciling in something like a $5 trillion figure. But these companies have got different levers to pull to finance that they can use private credit, they can use secured finance, they can use public bond markets as well as their own cash flow generation.
And if we think that maybe 10% comes from public new issuance, public bond markets, the matters are complicated, that's $500 billion over the next five years. And that would nearly double the weight that this tech segment has within global bond indices becoming something close to 10%.
In contrast to the.com bubble, the companies that are undertaking this investment today have got very established, very profitable existing businesses.
And if we're to project forward over the next five years, expectations for their cash flow generation in the dark green cash flow from operations. But then if we knock off shareholder returns, we knock off capital expenditure for the most, but not all. You still have a like green bar that's positive or they end up with free cash flow that's spare after undertaking all of that CapEx again reinforcing. There'll be winners, there'll be losers, there's opportunities, there's risks. Creating the security selection opportunities for the analyst team.
Bring it all together. What's the view? Harvey talks about? An overall duration environment that we expect to be tactical one year ahead. For 10 year treasuries. We're expecting 4.1% for gilts. That's 4.5% cross market.
As much as these are global themes, as we've seen already, they're not all priced the same. Favoring overweights in governments like Australia relative to the US as well as Germany versus Sweden within yield curve shape, the core view is a steeper US yield curve.
Front end's gonna be much more sensitive to the expected rate cuts. It's the long end that will feel the lingering concerns on fiscal policy and any requirements for term premium to increase.
But those risks aren't priced the same across regions. Relatively speaking, much more value at the long end in the UK as well as Japan.
And within inflation. There's some good trades to be looking at here too. Overweight US inflation expectations both outright and relative to Europe and the UK.
In our other macro decisions agency mortgage backed securities have become exceptionally expensive after recent intervention by US politicians.
And on the currency side, we favor longs in the Euro Norwegian kroner, but an underweight in the US dollar and the Swedish kroner.
Turning to credit in terms of the beta management or directional view, it's a positive cycle backdrop, expensive valuations leading to a more neutral posture for overall debt directionality.
And then on the macro credit, rv, EM'S attractive asset backs appealing to try and capture that cheaper risk premier on the country and the complexity side.
And as we move more bottom up in sector strategy, it's finding the opportunities from the private credit spillovers either in the BDCs or to some extent in the insurance sector.
And within security selection, the focus is all on the CapEx funding, the winners and the losers.
