26 Jul 2017
For years now we have become accustomed to solving our growth problems by layering on more debt. However as the financial system experiences an ever increasing debt burden, the productivity of each new dollar of debt declines. Albert Einstein once said, “We cannot solve our problems with the same thing we used when we created them.” Today’s central bank policies, combined with a meaningful increase in total global debt, will likely lead to a continuation of the problems of lower growth and a persistent lack of inflationary pressures. This shouldn’t necessarily be viewed as a conundrum that can’t be overcome by investors in global investment grade credit. It does mean, however, strong fundamental research, combined with an understanding of other key drivers of performance are required to capitalise on the opportunities in a low yield environment.
Central banks matter
Central banks have had a profound impact on markets and this shouldn’t be underestimated. We have experienced negative yields in Europe and historically low yields in many countries around the globe. They have contributed to an environment of lower volatility that breeds complacency and makes relative value discussions appear less relevant. However, investors should pay particular attention when central banks such as the Federal Reserve and the European Central Bank are taking steps to reduce liquidity by altering the rate of bond purchases. As the chart below demonstrates, there is a high correlation between total central bank purchases and risk premiums of investment grade credit.
US central banks purchase and credit spreads variation
Source: National Central Banks, Citi Research, Yield Book
One of the central banks’ key challenges today is exiting their non-traditional policies without fostering the instability they have worked to contain. Up to this point they have generally been supportive of markets and adopted policies to meet periods of higher volatility. Furthermore, as a matter of course, we shouldn’t anticipate they will abandon these tactics. If they don’t cast off these policies and continue to provide support to minimize financial instability, we should be more confident adding to favourable credits as risk premiums increase, while still resisting the urge to add risk when credit spreads appear to offer limited opportunities for price appreciation.
Historical trading relationships are not enough
Studying credit curves to determine the most attractive risk reward maturity for an issuer has traditionally been an additional source of alpha. But basing investment decisions solely on historical trading relationship can be an issue. For instance, prior to the Global Financial Crisis investors could have a higher degree of confidence when the US Treasury curve bear flattened (i.e. short end yields increase faster than long end yields) that shorter dated corporate bonds would outperform longer dated corporate bonds on spread. This historical trading relationship makes sense when considering the impact of higher rates on credit spreads, and how longer maturities would need to compensate more for the impact.
In recent years, however, this relationship has been less reliable with longer dated credit at times performing better than shorter dated credit when the US treasury curve bear flattened. This is highlighted by our models showing that between January 2016 and June 2017 the correlation between the 30 year and 10 year US treasuries spread was positively correlated to the US corporate credit curve spread (long dated spreads minus intermediate). While this correlation was negative between January 2014 and December 2015, as well as between August 2000 and the GFC.
There are a confluence of circumstances that may be contributing to these events including investors need for yield and long duration assets, as well as the requirement to invest capital that continues to flow into multiple markets across fixed income. This has resulted in more uncertainty and made investing in longer-dated corporate bonds more difficult. It also highlights the importance of reducing this uncertainty through a well-established investment process that includes strong fundamental analysis to fully understand the structures and credit risk of issuers across various maturities and instruments.
Using fundamental analysis, we have found investment opportunities in the US credit market in longer dated utility holding company paper. The higher quality nature of these issuers, combined with their multi-tiered capital structures, provides opportunities for price appreciation and additional yield. Having a disciplined process to add to names such as Anheuser-Busch InBev when credit curves approach the wider end of recent trading ranges has proved beneficial.
Fundamentals – they still matter
We gain confidence from the fact corporate fundamentals have been improving, driven by the strength of 1Q17 corporate earnings, due to stronger commodity prices year-on-year, a weaker US dollar, relatively easy comparisons given 1Q16 weakness, and improving sentiment from issuers’ management teams. Although there is still a high degree of uncertainty regarding future deregulation and tax reform, any progress along those fronts will provide additional upside for investment and productivity. Although leverage remains elevated and interest coverage has been declining, we are encouraged by the recent improvement in EBITDA and revenues across investment grade credit.
EBITDA growth of S&P 500 companies ex-financials
Debt / EBITDA of S&P 500 companies ex-financials
In today’s low yield environment it is important not to “reach” for yield where fundamentals aren’t supportive of pricing. Utilising our global credit capabilities allows us to continue to uncover opportunities in multiple markets by questioning the status quo. Understanding the opportunity set is always critical but particularly true in a low yield environment. The pathway to negative returns today is much shorter without the traditional yield fixed income investors were accustomed to collecting prior to the GFC. It is paramount we weigh factors across credit markets including, central bank involvement, risk premiums, yield, as well as industry and issuer fundamentals, before allocating capital in a world where significant debt burdens and non-traditional monetary policies have resulted in asset price inflation and skewed risks.