Special Report Credit: Avoid the flashpoints
Spreads and liquidity are two current (and seemingly perennial) concerns for investors navigating their way along the credit spectrum. To add to that, investors are now assessing the effect of the ECB’s announcement that it will extend asset purchases to investment-grade bonds: there is bound to be spillover into other asset classes.
Recent experience in some areas of credit has been rocky. In the past nine months or so there has been a dramatic fall in the oil price, combined with concerns about Chinese growth and fears (seemingly unfounded) of a US recession. These events sparked widespread sell-offs in emerging market debt and high-yield bonds.
By the end of February this year, outflows from US high-yield mutual funds had turned positive. A key question is whether this is a good opportunity to take positions in high-yield or emerging market bonds, or indeed in the newer category of emerging market corporate debt (which we explore in this report).
Spread widening in certain credit segments is not a one-sided story and the taper tantrum of summer 2013 shows how rapidly sentiment can turn. Volatility is not confined to high yield or emerging market debt, as the sell-off in the 10-year Bund last year showed.
In some cases, wholesale reassessment of the credit asset class could be appropriate as investors weigh the relative yields and economic growth trajectories of Europe versus the US and emerging markets.
Central banks are boxed in, as are European institutional investors, with 40% of government debt outstanding showing negative yields, according to Deutsche Bank last December.
The fixed-income diversification path is not a new one for European institutional investors, and yield compression has, for some years, forced investors along the credit curve. For some investors, tighter supply of suitable hedging instruments and unattractive yields have led to a wholesale reassessment of what constitutes a growth versus a liability portfolio.
On the one hand, investors are replacing ultra-low-yielding government bonds with long-lease alternatives such as asset-backed lending, or secure income streams from high-quality infrastructure. On the other, as they mature, they are moving out of volatile equities into credit, but also from low-yielding investment-grade bonds into high-quality CLOs.
For a few large players this can involve building up in-house resources in multi-disciplinary teams equipped to assess credit and handle complex loan documentation. But few have the resources to do this, which leaves many with a choice from among a plethora of multi-asset credit funds, some of them new. Credit is not a homogeneous asset class but a range of small markets with idiosyncratic characteristics. Hence, multi-asset funds tend to differ widely and the underlying exposure will vary according to the expertise available to the provider. As such, this report delves into a range of credit sub-classes, from emerging market corporate debt to leveraged loans, direct lending and bank credit.
Overall, there are more buyers than assets and much dry powder on the sidelines. Mercer warns of credit “flashpoints” where excess dry powder and investor demands lead to return compression. This means dynamism and flexibility are key drivers for success, both on the part of asset managers and institutional investors.
Pension funds and others will be rewarded not only for patience and long-term allocations to illiquid assets but in many cases also for the speed and flexibility of their decision making.
Liam Kennedy, Editor, IPE