Deteriorating debt covenant quality and a rise in the number of companies that were previously unable to issue bonds but are now doing so could be warning signs of a looming credit crisis.
But while the market should be worried about an increase in some types of debt structuring, the risk isn’t as great as it was in the lead-up to the global financial crisis (GFC), said Brandywine Global Investment portfolio manager and head of high yield, Brian Kloss.
“We’re seeing companies that couldn’t issue in the past couple of years now coming to the market,” Kloss said. “You have to start thinking about…the quality of the covenants, the quality of the business model, or businesses that are coming to market.”
The risks that create credit events happen most often outside of the credit market, Kloss said. To illustrate, he pointed to the 1990s currency crisis, the 2001 equity bubble, and the 2011 European sovereign crisis.
Average hourly earnings patterns and possible inflation will also affect fixed income investors.
“I think you’ve got to bring your quality [of credit] up, and that’s not necessarily ratings,” Kloss told a room of institutional fixed income investors at the 2017 Investment Magazine Fixed Income, Cash, and Currency Forum, held in Healesville, Victoria, in July. “Do your own homework on that credit. Understand what you like, own what you like, then maybe think about using some derivative instruments if you want to continue to bear some exposure but you don’t want to have specific credit risk.”
Brandywine’s global multi-sector strategy is to hold synthetic short and/or long positions in individual securities, indices, currencies and interest rates. Kloss said investors should consider the fundamentals but also the macros, to get a feel for where the credit market should be at this point in time. That means looking at rates, currency and credit when constructing a portfolio.
Real, high yields are available globally, he said.
“Generally, if you seek high yield you think yield hogs get slaughtered…but it depends on the buyer’s value perspective.”
The Philadelphia-based Kloss also described emerging markets as an interesting proposition.
“Our first allocations have been towards Latin America, South America, Mexico, Brazil, Poland,” he said. “India is probably one of the positions we’re a little bit more comfortable with, versus something like Argentina. We’re cash bond investors but will use [credit default swap indices] or interest-rate futures to deploy in the portfolios.”
Kloss said that in emerging markets it’s particularly important that investors think about allocating across different sub-sets of the fixed income market, “whether it’s a corporate or a sovereign [bond], whether it’s high yield investment grade, whether it’s RMBS [residential mortgage-backed securities] or even bank loans.”
Having flexibility enables managers to identify opportunities across the fixed income spectrum, which increases the chance of finding differentiated sources of income and returns.
Kloss described Brandywine’s approach as “benchmark agnostic”. While it is necessary to be benchmark aware, he said, it’s important not to succumb to the “tyranny of indices”, especially within fixed income.