Turning more bullish on US and UK investment grade credit
A widening in spreads has helped to renew the lustre of the asset class, according to Anthony Gillham, co-investment director of multi-asset unit, Old Mutual Global Investors
After grinding tighter for about four years, circumstances over the course of 2015 have conspired to push UK and US investment grade (IG) spreads wider, reviving the appeal of this section of the credit market.
Catalysts for the move include the government bond selloff of April-May, the China-induced summer wobble in risk assets, concern over the outlook for Federal Reserve (Fed) policy and high levels of bond issuance. Humming in the background amid all of this has been considerable anxiety among investors about the health of the world economy.
Indeed, while the US jobs market may be perking up to the point that the Fed may muster the courage to raise interest rates - for the first time in nearly a decade – other economic signals key for the global outlook are decidedly mixed.
Despite the trillions of dollars by which central banks around the world have expanded their balance sheets, there remains precious little evidence that inflation is re-asserting itself in a convincing manner. While forward looking survey-based measures exhibit some stability, market measures such as so-called breakeven rates show inflation expectations to be hovering near multi-year lows.
Meanwhile, oil prices, a key factor in the near-term inflation outlook, remain subdued.
Fed officials have made clear that any decision to tighten monetary policy would require reasonable confidence that inflation would return to the central bank's 2% target over the medium term. Hence their emphasis that any rate increases would be gradual, presumably in part to prevent fanning further strength in the US dollar, which would lower import prices and make exporters less competitive – both clear disinflationary forces.
And in Europe, their counterparts at the European Central Bank (ECB) are so concerned about the picture for consumer prices, and the threat of deflation, that they are considering loosening policy yet further. Mario Draghi, ECB president, said options include taking the deposit rate even further into negative territory and boosting the central bank's asset purchase programme. The Bank of England, for its part, has just downgraded its near-term inflation forecasts in its quarterly Inflation Report.
So in a world with the signals as mixed as they are and volatility still relatively high, what should a multi-asset investor who is charged with delivering consistent investment returns – as well as cushioning on the downside – do?
Our answer is to focus our team's considerable resources and experience on constructing all-weather portfolios that aim to cope well with uncertain outcomes. Accordingly, we have increased the diversification of our portfolios, in particular in fixed income, to offer protection against the risk that the global economy falls into deflation.
One of the most effective assets to hedge against such an outcome is fixed income. But as we know, valuations are still not particularly attractive: longer-dated government bond yields remain low in developed markets, even after the weakness inspired by the stellar US jobs report for October. And in the UK, for example, yields on inflation-linked gilts remain negative across all maturities – offering investors very little in the way of return for risk.
Fortunately for bond investors, credit spreads have widened considerably since the start of the year. At the same time, corporate fundamentals remain sound. While we see evidence of corporates re-levering their balance sheets, servicing that debt remains unchallenging, given low interest rates reinforced by the tendency of companies to take advantage of current favourable conditions and extend their maturities. This means the need to roll that debt over has been pushed out many years into the future.
For us, IG corporate bonds today offer an attractive means of achieving an exposure to the deflation-hedging characteristics of developed-market fixed income, but with a far better margin of safety available than at the beginning of the year.
IG spreads in the US and UK are now cheap, according to our valuation model, so we have turned more bullish – with room to increase this should weakness extend.