Why corporate bonds remain in good shape
Investors remain progressively more cautious in the near term, with rising risks emanating from China and related commodity markets, low bond yields, and ongoing geopolitical concerns.
While the broader European region is in good shape politically and has a strong policy toolset in order to protect against contagion, the ongoing bailout discussions and execution risks as well as anti-austerity party movement across the periphery will continue to drag on sentiment. We do see this as an opportunity to ultimately add risk due to underlying policy support, other broader macroeconomic data trends and valuation adjustments.
Global central bank policy and liquidity conditions continue to drive differing investor behaviour. Yet a rise in broader volatility across asset classes has ensured there is also an acknowledgement of liquidity and underlying positioning that may impact market pricing during this difference in timing and transition phase for global central banks.
Sharp movements in global bond yields year-to-date have underscored these investor concerns as we approach the first rate hike in the US and the interpretation of the next cycle. At this stage, we expect that markets to be volatile into the first hike; indeed, we have started to see signs of this playing out indirectly through linkages into emerging market stress. The risks of a more disruptive outcome are increasing, and we are positioning the portfolios defensively accordingly.
Overall from a credit perspective, corporate balance sheets remain sound as many corporates went into this phase of the cycle in great shape. The rise in leverage is not concerning, with coverage metrics having improved due to lower funding costs and the extension of debt profiles.
Top-line revenue (excluding energy-related sectors) remains constructive and cost-cutting over the years has provided support via operational leverage for future quarters. Further cost-cutting initiatives from here should be fairly limited, as will the benefits seen post-crisis from lower interest expense and lower effective tax rates. As such, credit headroom remains very solid, but it will be increasingly important for investors to watch out for corporates that have incentives to re-lever or are overly ‘shareholder-friendly’.
How we plan to manage ongoing uncertainty
We remain constructive but cautious (in the near term due to timing and transitioning) on the ‘top-down’ picture for credit. However, increased volatility and recent credit spread widening will ultimately provide an opportunity to tactically add back some risk, particularly as overall global policy conditions primarily still remain supportive.
Our macro-credit scorecard is moderately constructive on global credit over the next six to 12 months, and recognises that credit spreads continue to overcompensate for a benign default and volatility backdrop. While we acknowledge that the reduction in overall tail risk in Europe has aided investor sentiment over the last few years, China will test the market in the near term.
We are seeing signs that geopolitical tensions are becoming more prevalent and the oil price impacts have become much more embedded into sentiment, which may lead to recurrences of market volatility. We remain active and nimble, with the use of more liquid credit derivative markets to efficiently navigate through any volatility by focusing on regions, industry concentrations and credit quality to add value with much lower transaction costs.
These instruments also allow us to hold onto credit amidst volatile backdrops by utilising credit default swaps to hedge credit beta without having to give back stock to the market. We believe our active use of derivatives is a key competitive advantage and allows for a more robust performance outcome across the cycle. That is, our process has led us to hedge our credit exposure at crucial points.
Over the medium-term, we are focusing on sectors and issuers which should perform well despite a lower global growth backdrop that we anticipate will have a more meaningful impact on certain more cyclical sectors.
We are also monitoring supply-side dynamics and global relative value pricing as more primary issuance comes to market. Our preference is for exposures to defensive or non-cyclical industries, or to those credits which can illustrate solid deleveraging stories.
We continue to have a preference for Australian credit. We also prefer US credit over European credit due to an improved technical backdrop, improved economic data and less negative fiscal feedback loops, although we will be watching movements in bond yields closely as we approach the first rate hike from the US Federal Reserve.
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Recent volatility in global markets, ongoing geopolitical risks and diverging central bank policy means SMSF investors need to look even harder for investment opportunities with downside protection. Corporate bonds are traditionally considered lower down the risk spectrum than shares. Nevertheless, when exploring income investing from corporate bond issuance it is prudent to have a focus on investment-grade credit. While the search for yield leaves many investors with choices surrounding how much risk to carry, it is important to invest in companies with strong or improving corporate fundamentals and a solid management team with bondholder focus, whereby a normalisation of global growth could translate into revenue and earnings growth and further improvements in its credit profile.
About the author
David Carruthers is the Head of Credit and Core at AMP Capital where he leads the Global Fixed Income team’s credit and core bond fund capabilities and is responsible for macro credit strategy.