Below we summarise our thoughts on:
- Going global to target value in credit
- ESG factors are driving bond markets
- Building more suitable CDI portfolios
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Planning for the next credit cycle
Global investment grade spreads are about 100bp over government bonds. That’s expensive by historic standards. When you plot spreads over the last 20 years, we’re currently around the bottom 10th percentile of observations.
Therefore, we believe that investors need to think globally, as not all of these segments are as expensively priced as global investment grade credit (see Chart 1).
Widening the net is already a necessity for what are traditionally thought of as developed investment grade indices since they now include $2 trillion of exposure to emerging market credit.
Chart 1: By casting the net far and wide, pockets of value appear
Source: Insight, Bloomberg Barclays, JP Morgan, Credit Suisse and ICE, as at 31 December 2019.
Emerging or developed – the myth of domicile
Traditional distinctions based on domicile are becoming less relevant, for example:
- Telenor Group, the leading integrated telecoms provider in Norway, may be perceived to be a less exciting and steady developed market issuer. But 59% of its cashflow comes from emerging markets, with its second-largest market being Bangladesh.
- In contrast, Mexico-based Grupo Bimbo is perceived to be an emerging market issuer, but it is the largest baked-goods producer in the world. It has operations across the Americas, Europe and Asia and 59% of its revenues come from developed markets.
Similarly, the M&A backdrop has changed. Historically, developed market companies have purchased emerging market companies to diversify and accelerate growth. This has now changed; emerging market corporates have matured and are diversifying into developed markets. Furthermore, they are not just buying the offcuts unwanted by their developed market peers; they are buying premium brands and improving them.
The auto industry is perhaps a good example of this:
- 15 years ago, Volvo and Jaguar were declining high-end brands with poor product line-ups.
- Today they are both award-winning brands. Their revenues have doubled over the last decade and they are now clear rivals to the German automakers.
- The catalyst for their transformation was a change in ownership: Volvo has a Chinese parent, Geely, and Jaguar has an Indian parent, Tata.
Take a global approach
If you separate analysts to only look at developed market issuers then you are not able to identify the best opportunities globally at a given time. We can take the oil and gas sector as an example. Looking only at developed market issuers, BP and Eni stand out as offering some of the widest spreads for a five-year maturity bond. But when we expand this to cover a global universe you are able to get much higher spreads via investing in Sinopec, a Chinese company that is around the same size as BP but less levered.
We believe that ‘sustainability’ will be the defining term for the 2020s. This is likely to be visible in all aspects of our lives and the investment world will certainly not be immune to this.
Two investment solutions gaining traction
For some investors, values and performance are not trade-offs; they are a confluence. However, that is not the case for all investors and we see two different investment solutions gaining traction (see Chart 2):
- US: There is a reluctance to adopt ESG exclusions in portfolios as these are considered by many to be a breach of their fiduciary duty. As a result, the ESG solutions that are gaining traction typically emphasise the performance benefits of ESG investing. Allocating to companies with better ESG scores could improve returns and reduce volatility.
- Europe: Many investors have a similar mindset to US investors, but they also have a much greater willingness to imprint their values on portfolios. This is typically a greater emphasis on exclusions and a strategic focus on impact, and impact instruments such as green bonds. Notably, UK investors typically fall between US and European investor types.
Chart 2: Solutions can vary by jurisdiction and investor type
For illustrative purposes only. Source: Insight, as at January 2020.
ESG trends are beginning to impact markets
As investors start to pay greater attention to ESG trends in their portfolios, markets start to be impacted. For example,
- in 2019 not a single French order went into a tobacco bond issuance book
- five years ago French orders made up 20% of the tobacco sector’s issuance book
Where more investors are divesting from controversial sectors like tobacco, it becomes harder to find the marginal buyer. An investor may be comfortable owning short-term tobacco bonds where they have strong visibility over cashflows and might be able to access better carry opportunities, but would they buy a 20-year tobacco bond when this trend is taking place?
This feedback loop leads to higher funding costs for tobacco and other less desirable companies. It marks the beginning of an unsustainable spiral.
Investors should be wary of the ‘Inevitable Policy Response’
Environment appears to be a primary focus for investors. Over the next 10 years in corporate bond portfolios, climate change preparedness will likely be a key driver of alpha.
This may not be a gradual evolution, but rather one that takes place suddenly mid-decade when it becomes obvious that climate targets are not being met and governments are forced to come up with a step-change response which requires them to take more radical action. This is what the PRI calls the ‘Inevitable Policy Response’ and it is likely to catch out laggards who lack the flexibility to deal with such a step-change mid-decade.
Additional data and resources
To effectively integrate ESG into portfolio analysis there will be a requirement for improved data management. This may involve deploying things such as artificial intelligence or exotic data sets (such as geospatial data) to deal with increasingly complex issues. Improved data will also be required to provide new reporting beyond traditional financial metrics, requiring additional resources.
Overcoming the shortcomings of the UK corporate bond market
The UK corporate bond market is relatively small compared to other global credit markets. There is a fair amount of debt available at shorter maturities, but at longer maturities the market becomes small and concentrated. Issuance in longer maturities is sporadic, and liquidity is limited, with the market tightly held given heavy demand from domestic insurance companies.
In order to get better value, pension schemes need to go global. In US dollars, the corporate bond market is more liquid, has lower transaction costs and far more primary issuance. It is also possible to hedge credit back into sterling and pick up additional yield relative to purchasing the same issuer directly in sterling. This phenomenon has persisted for a considerable period of time.
The different types of assets for different maturities
When building a cashflow-driven investment (CDI) portfolio we believe that different segments of credit markets have a role at different maturities (see Chart 3).
- Sterling credit does have a role, but avoid cyclicals and look for asset-rich issuers and securitised credit when available. Liquidity is important, as these bonds may need to be sold if circumstances change.
- US dollar credit plays a key role – this is where it makes sense to take exposure to more cyclical issuers given the improved liquidity, but also diversify into whole new sectors not available in sterling credit such as railways.
- We would be more comfortable with sterling-denominated cyclical issuers, but investment grade credit tends to be expensive in shorter maturities.
- High-yield and asset-backed securities can be used to enhance yields and use capital more efficiently.
Mid-section of the curve
- Liquidity in traditional corporate bonds is poor in this part of the market – and this is reflected in spreads. To make better use of capital we would suggest private corporate credit. Lending here, in 10-year to 25-year tenors, is establishing itself as something of a new asset class. Having historically been purchased primarily by insurance companies, we are seeing a more diversified set of investors are entering the space.
- Private corporate credit allows us to gain exposure to new types of assets that are very different to traditional corporate exposure, increasing diversification. Examples include student accommodation, housing associations and utility financing. This is primarily investment grade credit, and the debt amortises over time, matching the underlying assets and thus removing refinancing risk.
Chart 3: Preferred CDI portfolio build
Source: Insight, Bloomberg Barclays, JP Morgan, Credit Suisse and ICE, as at 31 December 2019.
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The performance results shown, whether net or gross of investment management fees, reflect the reinvestment of dividends and/or income and other earnings. Any gross of fees performance does not include fees and charges and these can have a material detrimental effect on the performance of an investment.
Any target performance aims are not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
Portfolio holdings are subject to change, for information only and are not investment recommendations.
Associated investment risks
Fixed income, liability-driven investment and multi-asset
Where the portfolio holds over 35% of its net asset value in securities of one governmental issuer, the value of the portfolio may be profoundly affected if one or more of these issuers fails to meet its obligations or suffers a ratings downgrade.
A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.
The issuer of a debt security may not pay income or repay capital to the bondholder when due.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.
Where high yield instruments are held, their low credit rating indicates a greater risk of default, which would affect the value of the portfolio.
The investment manager may invest in instruments which can be difficult to sell when markets are stressed.
Where leverage is used as part of the management of the portfolio through the use of swaps and other derivative instruments, this can increase the overall volatility. While leverage presents opportunities for increasing total returns, it has the effect of potentially increasing losses as well. Any event that adversely affects the value of an investment would be magnified to the extent that leverage is employed by the portfolio. Any losses would therefore be greater than if leverage were not employed.
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