Go for credit

We currently see greater opportunities in credit where markets are closer to pricing in our downside scenario.

At a glance

We currently see greater opportunities in credit where markets are closer to pricing in our downside scenario. We highlight seven opportunities in this space, including US corporate bonds, USD-denominated emerging market sovereign bonds, and green bonds.

Most companies have now switched from shareholder-friendly measures to bondholder-friendly ones

On balance, we think credit markets are closer to pricing in the risk of our downside year-end targets materializing than our upside targets. We see a number of factors supporting the asset class.

  • In our view policymakers have done enough through their fiscal and monetary response to ensure liquidity issues do not become solvency issues for companies or sovereigns that were viable prior to the crisis.
  • Market technicals have turned supportive. Since March’s market dislocations, interbank and corporate funding conditions have improved, secondary market trading activity has picked up, bid-offer spreads have narrowed, and the new issue market has been strong.
  • Most companies have now switched from shareholder-friendly measures to bondholder-friendly ones in an attempt to defend their credit ratings.
  • Current valuations in credit compensate investors for the likely downgrade and default risks ahead of us.

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Here are seven ideas we highlight in the fixed income space

Emerging market hard currency sovereign bonds (EMBIGD). Yield spreads widened to more than 700bps in March from 290bps at the start of the year, reaching the 96th percentile of values in the last 15 years, a post financial crisis peak. Since 2000 there have been 52 months with EMBIGD spreads in excess of 500bps. Subsequent 12-month total returns were positive in all cases, with a median return of 13%.

In our central scenario, the coordinated monetary and fiscal response helps limit the economic downside from COVID-19 and we expect spreads to tighten to around 450bps.

US high yield (HY) credit. At current levels US high yield credit spreads still offer attractive returns. Since 1987, there have been 89 months with spreads in excess of 700bps, and subsequent 12-month total returns were positive in 87% of cases, with a median return of 17.5%. In our central scenario for the virus, we expect USD HY spreads to tighten to around 550bps.

US investment grade. We expect US investment grade credit spreads to tighten in the months ahead. Valuations are relatively attractive and policy from both monetary and fiscal authorities is supportive. Since 1988, there have been 37 months with spreads above the current level of just under 200bps. Total returns in the subsequent six months were positive in 73% of cases, with a median of 4.4%.

Green bonds. We see particular opportunities in green bonds, which we believe will exhibit lower volatility and smaller drawdowns compared to non-green bonds during periods of market stress, given their more conservative sector and credit profile.

Eurozone crossover bonds. In Europe, we look for select investments in the “crossover zone” between investment grade and high yield. The ECB is buying bonds, so corporate spreads should be relatively contained, and investors able and willing to stomach the potential volatility of “crossover credit” investments can earn potentially significant alpha if key rating agency action is anticipated correctly.

Asian IG and HY. In Asia, we prefer BBB within investment grade. We favor IG bonds, which can provide enough spread cushion to withstand the volatility in rates, including Chinese government-related issuers and select corporate bonds issued by Indian privately-owned companies. In the high yield space, we look for good-quality names. Within HY, we see value in select one-year China property bonds, which we believe are safe to hold to maturity from a liquidity perspective, and they should experience lower price volatility due to their short duration.

Talking points:

  • Overall we are neutral on stocks and see greater opportunities in credit.
  • We think markets particularly the US HY, US IG, and EM sovereign bond markets are closer to pricing in the risk of our downside scenario already, and there is room for strong returns if our central or upside scenarios play out.
  • Historically, when credit spreads are as wide as they are today, credit investors have enjoyed attractive subsequent returns.

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