Even though all eyes are on stocks thanks to the excellent performance of Wall Street, the bond sector deserves a careful look. Not only from a diversification perspective, but also from an opportunity perspective, given that returns have risen to decidedly interesting levels. Let’s take stock with Charudatta Shendehead of client portfolio management fixed income at Candriam.
What are the prospects for the credit market?
“Credit markets should benefit from the significant carry they are already showing. European investment grade credit allows investors to take advantage of very attractive yield levels, close to 3.8%, with a maturity curve that appears incredibly flat. Investors therefore have an excellent opportunity to achieve historical returns over a longer period in a relatively high quality asset class, certainly compared to equity markets, which feature lower dividend yields and higher volatility.Even global high yield markets are benefiting from the return of carry, with very attractive coupons above 7%, a very different scenario to that of two years ago, when they were slightly above 4%.These levels, last seen in 2011, are notable, if it is considered that since then the quality of the high yield market has improved significantly. The European one is now made up of 70% of bonds with a BB rating, compared to 50% in 2011, while in the US it is 50%”.
What are the biggest risks to consider?
“While investors have good reason to move with great momentum into credit markets, it will be essential to pay attention to idiosyncratic risks as bond yields are asymmetric. Without central bank support, companies and countries are increasingly dependent on fundamentals to justify their creditworthiness. In fact, it seems that we are moving from markets driven by central banks (i.e. monetary policy, rhetoric and guidance) to markets influenced by fundamentals (i.e. economic data, balance sheets and business models). Added to this is the growing importance of ESG factors, which continue to have a strong influence on credit risk. Furthermore, some elements will have a material impact on the ability of companies to meet their financial obligations in a context in which the cost of debt servicing has increased considerably. Current spread levels in both investment grade (130 bps) and high yield (nearly 300 bps) do not accurately reflect the risks to which credit issuers are exposed. Digitalization, automation and artificial intelligence are some of the secular trends that have dominated the markets and have a strong influence on business. An issuer’s ability to adapt their business model to this rapidly growing trend will be critical and provide a solid foundation to outperform their competitors.”
What about geopolitical risks?
“Geopolitical risks will have a significant impact on credit markets. We have already seen the impact of the ongoing conflict in Ukraine on commodities, while events in the Middle East are already driving up container shipping prices. Overall, these conflicts (and future ones) are likely to negatively impact supply chains and raise inflation. While this could potentially postpone central bank rate cuts, the more immediate concern is the increased volatility that these conflicts will likely create. It will also be important to monitor election results in a year when nearly 40% of the world’s population will go to the polls. In the United States in particular, the election will not only likely lead to greater volatility, but a potential Trump victory could lead to increased tariffs and, once again, increased inflation.”
How to move within the high yield segment?
“The high yield spread rallied strongly in the final quarter of 2023 and rates have already priced in a potential shift in monetary policy that created challenges in early 2024. We continue to see the high yield spread in Europe as more attractive than the US one and the fundamentals and technical data remain very well oriented, with potential new large issuers that could emerge in the coming months and a very limited net supply from the primary market, given that M&A activity remains limited. In the current environment, we remain focused on leading players with strong pricing power and a proven ability to pass on the costs of inflation. We favor issuers with prudent capital management and credit-friendly behavior. In terms of sector allocation, we maintain our underweight exposure to rate-sensitive sectors (real estate, chemicals and construction) and remain overweight defensive and energy-intensive sectors (telecommunications, packaging, healthcare and utilities).”
So do you recommend looking at European or US high yield?
“European high yield is a generally smaller segment (in terms of number of companies and debt size) but better rated than the US. Over the last year, the Old Continent has seen many more companies emerge than to its US counterpart. Typically, European high yield trades lower (in terms of spread) than US high yield, but this has no longer been the case since 2022 following the Russian invasion of Ukraine. It is also important to note that, in In terms of sectors, energy (including oil and gas) represents more than 10% of the US high yield market, while it is a much smaller portion in the European market.”