European bond market investors need to be following political developments closer than ever, now that markets are expecting Greece and Portugal to restructure their debts.
“Uncertainty over financing has created greater yield at the short end, although there has been a more generalised credit spike, too. But there has been more stability at the long end,” he says. “There is, however, the risk of an EMU exit. The EU cannot remove a member state but a member state could decide to leave.”
In investment terms, this has led Anderson to focus on the core and not the periphery within sovereign debt, and SSGA has now switched from negative on Spain to neutral.
Sovereigns or credit are not where he views the best opportunities.
“Credit is fairly valued now but we still have a historically structural overweight to credit versus sovereign debt. Much of the rally has happened and there is still risk appetite out there, so we broadly favour equities over debt, although there are caps on how much many institutional investors can allocate to equity,” he says.
Overweight within credit
Anderson is overweight corporate debt and prefers to focus on the lower end of the investment grade spectrum and, where mandates allow, on high yield bonds. This has been his broad focus for the past quarter. He has even looked at a few corporates in Europe’s troubled periphery.
“We have been analysing some lower investment grade corporates with headquarters in Ireland, but a multi-national exposure,” he says.
“They have been affected by wide spreads in Ireland but their sound financials represent opportunities.
“You need to focus on the fundamentals and on the sources of revenue to make those calls.”
After the broad-based spread tightening in credit over the past two years, Anderson argues investors have to take a more granular approach, focusing on specific credits and particular risks. That is where idiosyncratic risk naturally comes to the fore in investment decisions, still offering opportunities for investors to find potentially profitable discrepancies in the market.
“It is time to move towards a more discriminating approach by looking at companies with a better return on assets and better interest coverage,” Anderson argues. “That means moving away from an index that might contain large proportions of specific issuers with high leverage on their balance sheet towards a more idiosyncratically favourable route.
“Another way to accommodate that idiosyncratic focus is by using a standard active process, either a quantitative or, in our case, a fundamental one. Those approaches work better than a weighted benchmark approach in the current investment cycle. Further through the cycle, greater divergences and idiosyncratic issuer volatility could be negative to portfolios.”
Since the financial crisis, structural imbalances have been created in much of the developed world by the shift of a large amount of private debt to the public sector. This has not yet been reflected in interest rates or government bond yields – particularly US Treasuries. But Anderson says, the environment of low rates and yields can’t continue indefinitely.
“[With higher rates] we would see the emergence of sovereign credit as a potential issue, with sharply higher yields and potentially inflationary conditions as well – all of which would land us in a very negative place, indeed.”
No wonder, then, that the market is so focused on the likelihood and timing of rate rises in Europe, the UK and the US. This is acknowledged as especially important in light of the size of debts governments are having to pay off at a time of slow growth.
“In the long term, interest rates will rise, so government bond yields will rise right across developed markets. It may be either very sharp and sudden, due to a failure to deal with public finances, or it may simply come out through economic progression as a gradual rise in rates,” he says.
“For investors benchmarked off Treasuries, that means widening yields and pressure on returns. For other investors, that means looking into shorter-duration exposures.
“For defined benefit pension funds, which at least have more of a liability-driven investment focus than in the past, it means thinking about how big their bet is in terms of positioning and duration.
“Then they need to work out how to take advantage of that as Treasury yields begin to rise, and how to start changing the risk profile between debt and equity in their portfolios,” he adds.