Fixed income monthly
THE END OF THE CREDIT CYCLE
As the end of the credit cycle draws near, we recommend refraining from descending the credit-quality spectrum, as we see justifications for higher default rates during the next downturn; other reasons to hold off are the deteriorating liquidity picture in credit trading and risk-free rates at depressed levels. Investors wishing to improve their risk-adjusted return profiles can act by strategically expanding their investment field across global fixed income segments, adjusting their allocation tactically during the cycle and sharpening their selection skills.
As all-in bond yields are flirting with record lows across many fixed-income segments, the temptation is high to descend the credit-quality spectrum to maintain reasonably attractive all-in yields in fixed-income portfolios. As the global economy is already in its 7th year of expansion following the traumatic Great Recession episode in 2008-2009 and as default rates have already started to climb, it is worth examining whether now is the appropriate time, and how investors can optimally improve portfolio yields, while mitigating shortfall risks.
We believe that there are reasons to believe that default rates will be higher and recovery rates lower during the next default wave: first, the level of total debt is higher in aggregate and relative to output, reflecting higher leverage ratios. World debt to GDP has swollen from an already record high of 269% in 2007 to nearly 300% according to McKinsey, with average world GDP also lower by nearly 1% compared to the previous decade, therefore undermining debt repayment capacity. Moreover, past debt excesses were not resolved during the prior cycle, leaving many companies with an unsustainably high level of debt. It is fair to say that fiscal or monetary authorities’ room to manoeuvre will be limited during the next credit crisis, in terms of ammunition and also likely from a political standpoint.
Another issue in today’s credit markets is the sharp deterioration in the liquidity of credit trading.
There has been a sharp drop in trading volumes and less market depth, mainly explained by the material withdrawal of investment banks from the fixed income business on the back of stricter capital regulations, thus fragmenting financial intermediation. According to the New York Federal Reserve, which reports primary dealers’ corporate bond inventory, the amount held in corporates has shrunk by approximately 75% since 2007, causing some exaggerated and erratic price moves and widening of bid-ask spreads during risk-off episodes. On top of default risk, lower liquidity conditions may increase shortfall risks in the riskier credit segments going forward.
Finally, credit-free bonds such as high-quality government bonds are already trading near zero nominal rates or even in negative territory – as is the case for more than USD 6 trillion of government bond debt – which weakens their safe-haven feature once the credit cycle turns. As a result, bond investors cannot count on a major yield drop on government bonds (i.e. price appreciation) as a true hedge in their bond portfolios. In 2008, for example, a 10Y government bond yield dropped from 4% to nearly 2% from September to December, translating into a 15%+ total return within 3 months. With government bond yields already very low, one can reasonably consider that the potential drop in credit risk-free yields will be smaller once the credit cycle turns, and will be less of a hedge during credit downturns.
To improve their risk-adjusted return profiles, bond investors can act on three levels: strategic, tactical and selection. Strategically, we believe investors can improve risk-adjusted return by expanding the investment universe and adding global fixed-income segments to diversify as much as possible the price fluctuations and sensitivities to various fundamental sources of risk (e.g. markets, sector, country, inflation, cycles, emerging premium).
From a tactical asset allocation standpoint, dynamic allocation across these segments can also add value by preferring segments that offer the highest risk premia per unit of shortfall risk, as we believe is the case today for Corporates and Emerging Local Debt (upgrade from neutral to overweight).
Finally, we strongly believe that fundamental credit selection is becoming crucial as idiosyncratic risk is on the rise, but high diversification in terms of countries, sectors and issuers must be maintained. During liquidity-driven corrections or higher waves of default, picking the right credit issuers in the right structure is decisive and can make all the difference. It is not a luxury.
IMPORTANT INFORMATION – GENERAL MARKETING
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