Under vanilla skies – outlook for fixed income markets
Strong credit fundamentals, stable leverage, low default rates and high interest coverage, means that global fixed income markets are currently a profound shade of vanilla. So says Andrew Jackson, Head of Fixed Income at Hermes Investment Management, in his quarterly market update.
As a credit investor, my natural outlook is pessimistic to catastrophic. Despite all of my natural instincts, across the corporate world, balance sheets look robust, leverage is not imperiling companies and interest coverage ratios are good – even when likely interest-rate increases are taken into account. True, the financial state of the UK high street is ugly, but we do not think that its current wave of defaults and restructurings is a forerunner of the much-anticipated end of the credit cycle. We may have to wait longer before that happens.
As liquid credit curves have steepened, we prefer longer maturities. At the long end, there is an attractive combination of relative under-ownership, superior roll-down and convexity. In emerging market (EM) credit, our appetite is for investment grade over high yield. Since 2015, there has been a lack of dispersion risk priced in to EM high yield compared to EM investment-grade credit. As a result, we prefer investment-grade to high-yield EM issuers, particularly when the company demonstrates improving environmental, social and governance (ESG) fundamentals. At a regional level, the underperformance of Latin America on a year-to-date basis creates an opportunity for tactical allocation of capital to this region.
We have seen UK and European yield private debt premiums shrink due to stronger UK growth. There has also been a significant improvement in the UK mid-market M&A pipeline, causing pricing competition to fall and midmarket loans are now providing a yield premium of about 85-100bps relative to euro-denominated loans. The retail and hospitality sectors, which are currently experiencing some stress, remain a concern in the UK private debt market and this has led to a rise in loan defaults.