Lacklustre global growth, persistently low inflation and geopolitical uncertainty all mean that interest rates now sit at record lows in many countries. It is likely that policy rates and government-bond yields will stay relatively low until there are signs that economic activity is improving in a meaningful way.
Over the past year, US 10-year government-bond yields have fallen from 3.25% to 1.5%. And in Germany, yields have declined from 3.5%-4.5% before the financial crisis to around zero this year. Because of this, coupons across global credit markets have plummeted and now stand at all-time lows (see figure 1).
Figure 1: Coupons fall across credit markets
Source: Herme Credit, ICE bond indices, as at December 2019.
This has had several knock-on effects. Firstly, refinancing debt with lower coupons has had a positive impact on fundamentals. Record-low coupons improve coverage ratios and reduce pressure on cash flow, meaning companies have more headroom to avoid defaults. As long as companies are proactive and manage the maturity wall, default rates should be lower during the next recession.
But lower coupons also make it harder for investors to recover from the high volatility that tends to come with lower-quality credit. This, coupled with the fact that weak covenants mean that recoveries will likely be lower during the next downturn, has led to decompression. The B and CCC-rated sections of the market have underperformed BB-rated securities, as investors favour issuers that have the means to withstand volatility.
In this environment, it is more important than ever to manage fixed-income characteristics like convexity. The call price is linked to the coupon on a bond, which means that lower coupons result in depressed call prices. At Hermes, we believe that an unconstrained approach to high-active-share credit investing can help navigate these difficulties and seek the upside even in a low-rate environment.