The line from central bankers’ great monetary policy experiment, through zero interest-rate policy and quantitative easing, to the current environment where more than $17 trillion of global debt trades with a negative yield is fairly clear for experienced fixed income investors: Central Bank A lowers rates; Asset B lowers in yield as a result; assets C to Z reprice as portfolio managers are forced to sell asset B and invest in something with a higher yield to maintain their previous portfolio-level yield. This results in lower yields almost across the board. Even erroneously named ‘High Yield’ bonds are now trading at a negative yield.
However, sections of credit markets have resisted the gravitational pull of loose global central bank policy. These companies stand at the outer limit of the credit universe and tend to have incredibly high levels of leverage, inhabit a sector that is undergoing major stress, or have an idiosyncratic story that makes them almost uninvestable. The yields in this portion of the market remain high as investors are repelled by the higher likelihood of credit events in these companies. We believe that the rising number of corporate failures is a sign that lender discipline is alive and well.
Investors need to keep an active watch
Taking a flexible approach to credit investing will always make sense in our view, however, it is particularly pertinent in this perverse market. Managing liquidity is central to our flexible credit ethos. Ultimately, the risk of any given credit is inextricably linked to the liquidity of the position.
Liquidity is never a permanent state of affairs. You need only look to the last financial crisis where the collective unwillingness to question growing liquidity risks was, perhaps, the biggest oversight. Retaining a strong dialogue between the execution team and portfolio managers is crucial to stay abreast of the latest technical developments and challenge assumptions about future liquidity.
Our flexible-credit philosophy and embrace of the illiquidity premium – including dynamic allocation between illiquid and liquid assets - are fundamental to the way we work. But there is a limit; there are certain assets that we would never include in specific funds and mandates. We constantly refer to our investment mantra when constructing credit portfolios – understand the mandate.
As a result, successfully positioning yourself in this market is possible for those able to seek out opportunities. However, the nature of our investment style means that we, for now, inhabit the most liquid parts of public-credit markets.
As the 31 October Brexit deadline looms, we will keep a close eye on all asset classes but the flurry of structured-credit issuances set for September marks this space, in particular, as a must-watch arena.
Prepare for attack
Our top-down view is that most markets appear rather expensive. We also worry about the perception that ‘bad is good’ as well as the recent actions of central banks.
At a portfolio level, within the most liquid parts of our markets, we think that cash assets look better value than synthetics – perhaps because shorts have been squeezed out. We still see a meaningful illiquidity premium in some sub-asset classes, but issuance has slowed to a snail’s pace in many markets, making access problematic.
Finally, we still favour lending to the higher quality parts of all of the markets we invest in with the aim of avoiding the upcoming defaults and low recoveries that we see on the horizon. Sometimes the best form of attack is defence.
To read the Hermes Fixed Income Quarterly in full, please visit the Hermes website.