Yields likely to remain low in the eurozone, says AXA’s Iggo
“When yields are low there is an increased need for certain investors to be more focussed on the volatility and the cost of managing their corporate credit portfolios,” says Chris Iggo CIO Fixed Income, AXA Investment Managers.
“The real challenge for managers is to build portfolios that offer the best risk adjusted return for the lowest cost, which tends to point towards portfolios that have low levels of turnover and transaction costs. This approach is also suited to the structurally lower level of liquidity that is evident in investment grade credit markets today.
In the euro area, yields are likely to remain low for a long time, as long as credit fundamentals don’t deteriorate. The European Central Bank (ECB) policy stance, low inflation and significant spare capacity all work against a large increase in bond yields even if the US and UK markets do see higher rates. Opportunities for active asset allocation within the investment grade market have been reduced by the compression of spreads in the last two to three years. Thus the focus should be on getting the credit assessment right, minimising turnover and seeking exposure to those parts of the market that provide the best risk adjusted yield.
Lower for longer – If we believe that interest rates in the United States (US) are set to remain relatively low for the foreseeable future because of the notion of being in a permanently low growth and low inflation environment, then the outlook for interest rates in the euro area is even more biased towards lower for longer. Fiscal and structural constraints on growth in Europe are more severe than in the US and recent relative economic performance suggests that the path of interest rates in the two major western economic blocks can diverge along the lines currently suggested by medium term bond yields. The message from the ECB in June was that official policy rates will be kept close to zero for up to another four years. In the absence of any rise in inflation or acceleration of economic growth, this means bond yields remain low.
Challenging to manage credit in a low yield world – Borrowers are likely to continue to take advantage of this low rate environment in Europe and bond issuance should pick up again after the summer lull. For investors, however, the ability to increase the yield on portfolios of investment grade credit will continue to be limited. For constrained investors this poses a significant challenge especially where regulators or trustees impose restrictions on credit quality, subordination and liquidity. For European institutional investors that need to hold a substantial proportion of their portfolios in good quality fixed income assets considerations of cost and volatility are as, if not more important than purely thinking about excess yield. Yields are likely to remain low and investment grade credit is increasingly being held as a liability matching asset with the focus on having an exposure that retains its credit quality over time, that is not costly to manage and that adds no unnecessary volatility to the overall investment strategy.
Fundamentals still solid – Our view on the investment grade sector in Europe is positive. We place a high level of importance on the technical factors that affect both the supply and demand for bonds. Supply is generally restricted by the deleveraging trend. However, this is largely a result of the reduced reliance of the banking sector on funding in the bond market. This has meant a negative net new supply of issuance but it also means a change in the composition of the bond market with new types of issuers and instruments emerging in the wake of the financial crisis. On the demand side, there remains a strong institutional bid for credit which in itself is driven by the very low levels of government bond yields but also the need for insurance companies and pension funds to hold safe core assets. But we are also comfortable with the fundamentals. Banks are better capitalised such that senior debt is very safe, while cash-flow and interest coverage metrics are very comfortable across the market.
For some investors, low turnover, low cost credit portfolios are the best choice – So how should investors manage their credit portfolios when it is clear that returns are going to be quite low but also that they have no choice but to hold lots of investment grade credit? Our view is that the focus should be on maximising return relative to volatility and minimising transaction costs. Building portfolios of credit that do not rely on benchmark weights or composition and don’t require investors to sell bonds when they get too close to maturity or when they are downgraded below investment grade, should result in a better risk-adjusted performance over the course of the cycle than purely following an index. If these portfolios can be built on the back of a solid credit process and with a focus on the parts of the market that deliver the best yield per unit of risk then they can also be managed with much lower transaction costs than a typical benchmark approach. By avoiding the limitations of benchmark investing the volume of turnover can be limited and the cost of managing bonds can be reduced. For investors that are less constrained by matching liabilities or regulatory requirements, a more active approach is desirable. However, given the absolute level of yields and the compression of spreads across sectors and the capital structure, the more flexibility there is in terms of management, the better. This means the ability to add high yield or subordinated bonds when markets are performing well and to increase defensiveness in safer government bonds when the outlook is less clear for credit.
High yield reacting to increased risk noise – I am not worried about wholesale selling of investment grade in any kind of market environment that leads to an increase in spread volatility. It does not seem to me that the investment grade market has been a popular destination for the kind of money that exits at the merest hint of a turning point. High yield is more of a concern in that regard, as highlighted by the Financial Times last week. To me, any volatility in high yield driven by outflows is consequence of asset allocation decisions that are a result of valuation concerns and also by the fact that many investors might be looking at high yield and equities and thinking that returns have just been too good. Recent news has not been conducive to staying with the risk-on trade and certain news stories could get worse, impacting investor confidence. As I wrote last week, cash might not be a bad asset in the near term. There are a number of risks to worry about – Russia, the Middle East, the Banco Espirito Santo story in Portugal, Argentina possibly defaulting on payments to the holdout bond holders – and there is not much of a cushion of yield to protect investors from an increase in volatility. High yield returns have been negative in July so far even though underlying government bond yields have declined.
Back to 2007, at last – Finally a word on the UK. Last week we got the GDP data for Q2 showing that UK economic activity has surpassed the level of the peak of the previous business cycle. It’s taken a long time to regain the output lost during the great financial crisis and despite the UK being the fastest growing of the G7 economies, its actual level of GDP relative to the 2007 peak is still lower than many competitors, such as the US and Germany. At the end of 2007, the unemployment rate was around 5.25% compared to 6.5% today, so there is potentially some significant spare capacity still to be used up. Inflation is about at the same level but wage growth is significantly lower as it was running at over 4.0% year on year back then. We are clearly not at a level of tightness in the labour market that is generating increased wage levels because there is, presumably, still a lot of competition for the number of jobs available. I’m sure there is an interesting behavioural aspect to what is happening here as it has been a long time since employers were willing and able to grant pay increases and since employees were in a strong enough position to push for higher pay. It’s hard to get too bearish on inflation until this situation changes and it is this that may make the Monetary Policy Committee (MCP) stay on hold through the end of this year. Gilts have certainly not traded like there is a monetary tightening cycle about to begin and it is going to take either some further hawkishness from MPC members or evidence that the wage and inflation cycle is changing for the market to really sell off. For the time being it is strong growth, low inflation and stable interest rates in the UK. I bet the government rather wishes the election was now rather than next year.”