HSBC’s Pakenham sees credit opportunities in a rising interest rate environment
Marcus Pakenham, product specialist Fixed Income at HSBC Global Asset Management, considers the positioning of fixed income investors in the medium term, given possible changes to yields as QE programmes cease and global economic growth continues to recovery.
We expect that government bond yields will trend higher as global economic growth improves and some QE programmes cease expansion. In this environment, government bonds and high grade corporate bonds may struggle to achieve positive returns with low starting yields and the headwind of rising yields. By contrast, we believe that lower rated corporate bonds such as BBB rated and high yield BB and B rated areas can provide attractive returns for investors in this scenario. These areas have higher starting yields and the duration, or sensitivity to movements in government bond yields, is generally lower than for higher rated corporate bonds.
We believe that the improving economic environment should be positive for company fundamentals. The quality of company balance sheets is affected by economic conditions with rising sales and healthy liquidity conditions generally good for company fundamentals. In particular, defaults in high yield are usually linked with broad financial distress and difficult economic conditions, which we do not expect. Economic performance has been reasonable this year, given the impact of government austerity campaigns.
The IMF has estimated that the impact of this fiscal drag in 2013 has been -1.8% in the US, -1.1% in the UK and -0.8% in the Euro area. We expect that economic growth should improve in 2014 partly helped by these ‘fiscal drags’ easing to -0.7%, -0.9% and -0.1% in these respective areas, according to the IMF.
Unlike governments, the corporate sector ,ex-Financials, was in pretty good shape going into the economic crisis in 2008/2009 with reasonable balance sheets, good margins and healthy cash flow. Since the crisis, this broadly conservative stance has placed the corporate sector in a strong position to ride out the subsequent economic landscape with growing cash flows in most sectors in the US and Europe. As US economic growth picks up and Europe emerges from recession, we are seeing moderate growth of company leverage in some areas, but cash flows (EBITDA) remain robust and ratios that measure the ability to service debt are well within acceptable ranges. The graph below shows the ability of high yield companies to service debt with cash flow. This ratio is already at a healthy level.
Global high yield: EBITDA/interest expense
The 2008-2009 financial crisis clearly highlighted banks’ exposure to US mortgage debt and Euro sovereign debt. The subsequent loan losses and pressures on capital have required significant efforts to repair balance sheets with new capital or retained earnings. In addition, banking regulators in the US and in Europe have been engaged in a process aimed at improving the resilience of banks to systemic shocks. The main points of this process are the strengthening of the capital base, both in terms of quantity and quality, and stringent restrictions in terms of risk taking. These efforts are yielding results as the capital ratios of US and European banks have improved over the past four years.
Corporate defaults are at a low level and below historic averages, as a result of prudent financial policies that most issuers have adopted since the crisis (focus on cost cutting, paying down debt, increasing debt average maturity etc). Major ratings agencies currently forecast a continuation of these below-average default rates.
High yield bond default rates
We expect that most government bond markets will face higher yields as global growth improves, QE programmes are adjusted and we move closer to policy rate increases.
In this environment, government bonds and highly rated credit, on low spreads, may struggle to achieve positive returns. By contrast, lower rated parts of the credit market can provide higher yields and lower duration. In addition, when government yields are rising these lower rated bonds can achieve attractive returns as spreads often fall with the improved economic conditions helping company fundamentals.
The lower rated bonds that we believe are attractive are typically BBB, BB & B rated. By contrast, we expect that the more highly rated bonds, such as AA A rated, will be more vulnerable to higher government yields. CCC rated bonds have high yields, but there is a much higher chance of default which increases volatility. Through a cycle, CCC bonds tend not add extra return, but are much more volatile.
We also believe that there are advantages in investing on a global basis. This provides a larger universe of companies and bonds, with a diversified mix of sector influences. There are also differences in economic factors and company performance between regions which can provide opportunities in asset allocations. We can seek out the best return for least risk.