Credit markets face daunting outlook
Fixed interest is a challenging asset class and there are many reasons for investors to be worried as central banks begin unwinding the large balance sheets they’ve accumulated over the last decade, two top fund managers have said.
GAM Investments investment director Tim Haywood, whose global firm has $200 billion in assets under management, gave the frank assessment that bond investors would see some pain, with forecast flat yield curves, little spread between long- and short-term bond rates and no signs of recession in a quantitative tapering environment.
Haywood cautioned that investors may have to endure a moderate capital loss on long-term bonds if quantitative tightening creates a “buyers’ strike” for bonds.
The US Federal Reserve, which underpins the world’s biggest bond market, had increased its balance sheet by six times pre-GFC levels before it began tapering back in 2013. Any new issuance from the US Federal Reserve would be well telegraphed, learning from that nasty experience of 2013, Haywood said.
“My concern is there will be a buyer’s strike,” he said, adding that global growth will lead to low default rates and “most people are funded long so there’s no refinancing risk of any immediate nature. The problem is if you’ve got a 10- or 20-year bond out there, it’s going to have several owners before it matures … At some point, the great $5 trillion shift out of [bonds to equities] might be reversed or we’re going to find ourselves moving bonds like a parcel between us.
“Maybe we’re the ones who will be the mugs and will have to endure a moderate amount of capital loss as these things get repriced lower to a level where a margin of safety is rebuilt into it.”
For Australian bond buyers to run their 10-year yield average in the next two years, this could translate to a 4 to 5 per cent annualised loss, he said.
Haywood is a business-unit head for fixed income at GAM, with responsibility for the firm’s absolute return bond family of funds and various long-only fixed income mandates. He made his comments during a recent visit to Australia to speak at the Investment Magazine Fiduciary Investors Symposium, held in Healesville, Victoria, November 13-15, 2017.
A rosier view
Joining Haywood for a panel discussion on the topic ‘Navigating central bank-driven fixed interest markets’ was Eaton Vance portfolio manager John Redding, who was more positive about floating rate debt and saw investors attracted to leveraged finance markets.
There has been a correlation between rising interest rate environments and loan defaults over the last 30 years, which has generally been a good thing for credit managers, he said.
The economy is “in pretty good shape”, he argued, and because inflation is not yet showing its head, this cycle of rising interest rates and higher returns on loan funds will be flatter and slower than previous cycles.
“As a credit guy, I’m not too happy…I realise we’re long in the cycle and at some point, there will be another default cycle and a trend towards rising rates will be coming,” he acknowledged.
Eaton Vance is a Boston-based investment management firm with $US395.3 billion ($524.3 billion) under management.
Redding said public company data was healthy, with interest rate coverage at four times and good earnings, with the exception of US retailers, which were 5 per cent of the overall loan market and under pressure from Amazon and other competitors.
Collateralised loan obligations (CLOs), now about half the US$1 trillion leveraged loan market, is an asset class showing “good flows”, he said.
CLOs, often backed by low-rated corporate loans, are attractive for investors who were “willing and knowledgeable” enough to handle their lower liquidity and higher volatility, he said, adding that recent tranches of BB-rated CLOs would find 300 basis point premiums and expected credit losses of “essentially zero”.
But Haywood said flat yield curves going forward for traditional credit markets, particularly without a recession on the horizon, would lead to investors finding better returns with equities.
“Taking credit risk on board has been incredibly lucrative in the last five years, smooth with a great set of ratios on the alpha you could’ve created and [avoided volatility],” he said. “The problem is we’ve painted ourselves into a corner.
“Traditional credit is getting pretty tight. European high-yield bonds (2.8 per cent) yield less than the US long bond (at 2.9 per cent), which is really pretty skinny.
“It’s been a magnificent ride to get here,” Haywood said. “But from here on, if you like the company, buy the equity.”