Bond Investing Strategy for August 2012
Stay safe in August: US investment grade corporates and high rated high yield offer the best risk reward.
We hesitate to increase exposure to risk in the coming months. The EU summit lowered the global political risk backdrop, but comes as slowing economic growth in most major economies is gaining pace and summer liquidity doldrums usher in. The acknowledgement at the summit to “break the vicious circle between banks and sovereigns” with the eventual creation of a European banking authority has boosted confidence, but implementation remains several steps away, leaving uncertainty high. Nevertheless, slow (but positive) growth in the rest of the world provides a good environment for highly rated credit markets.
Investment grade credit doesn’t need strong growth to perform well. On the contrary, it benefits from slow growth, in that a (albeit unlikely) return to stronger growth could divert allocations to equities and away from credit. This month, as safe haven sovereign yields dip deeper into negative territory and equity markets vacillate according to the latest data or news reports, the search for yield becomes more complicated. Yet, we’re relatively sure of two things: 1) global growth is slowing and will prompt, if anything, more monetary easing rather than tightening, and 2) tail risks remain high and will not disappear quickly given coordination and governance challenges (Eurozone) and fiscal tightening amid political posturing (US).
It’s a fine balance between slow economic growth and systemic risk which, in our view, will continue to lend support to highly rated credit markets. US IG has posted 6.5% total returns since the start of the year and relative outperformance so far this quarter (1.6%, behind only EM sovereign debt at 1.7%). Spreads in European IG meanwhile tightened sharply after the EU summit, and given weaker liquidity in this market than the US market, we prefer to maintain a marketweight allocation. But we like the flexibility inherent in US IG, even if additional spread tightening seems limited (at 205bps over USTs). Furthermore, fundamentals remain strong with solid US HG balance sheets (net leverage less than 2x EBITDA and interest rate coverage > 9x). In the current environment, the lack of alternatives to find yield and relative liquidity of the US market vis-à-vis the European corporate credit market is enough of a reason to take a closer look at high grade bonds in H2. Our other preferred markets include Asian IG and highly-rated US HY (for carry), as volatility could create interesting investment opportunities.
Nothing has changed fundamentally regarding our negative view towards sovereign bonds. Since our last committee, non-euro safe haven sovereigns (USTs, Gilts) have hit new historical lows. In our view, the market remains too expensive to warrant increased exposure. Having said that, there are sovereigns which we do believe offer value. Mid-core European issuers (Austria, Belgium, France) continue to look interesting, as do several emerging market sovereigns, where fundamentals are sound and relatively more ‘predictable’ than DM at this time. We remain constructive about Peru and Turkey, as well as Indonesia, given recent underperformance.