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Letter from America

Fraser Lundie, CFA, Co-Head of Credit and Senior Credit Portfolio Manager
14 March 2016

Earlier this month, in what is fast becoming an annual fixture, I was in the US for the JP Morgan Global High Yield and Leveraged Finance Conference. In addition to being an excellent opportunity to exchange wintry London for Miami heat, this event has been extremely valuable in highlighting structural market trends, organising company meetings that shed light on corporate America at critical points, networking with market participants to discuss concerns, opportunities and positioning.

As expected, the 2016 event provided some noteworthy takeaways:

  • High yield is on the rise: This year’s conference saw record attendance, with 1300 delegates from the buy side alone, and some in attendance were forced to stand. The market has grown in the last few years, now standing at about $2tn, and with that comes more analysts, more traders and more portfolio managers engaging with the asset class, assessing the pain but also the possibilities.
  • Relative value across the Atlantic: A consensus view among conference participants was that US high-yield credit now provides better value than European high yield for the first time since the eurozone crisis. This reversal was evident in the opening night dinner for Europe-based delegates. In years gone by, this was attended by a few people advocating the view that investors should not focus exclusively on either the US or Europe, but both. Now, with bank disintermediation, corporate consolidation through M&A the emergence of global credit strategies and relative-value opportunities with companies increasingly issuing debt in both dollars and euros, have all aided in the creation of a truly global high-yield market.
  • High yield is officially global: Evidence of the globalisation of the asset class was also obvious at the adjacent JP Morgan Global Emerging Market Corporates conference. A few years ago, there was no crossover between the two. Now they are synched by necessity as the events share many of the same delegates. This year, the emerging-markets conference drew a high number of European participants, saw corporate executives discuss foreign-exchange headwinds and international growth drivers, and the synergies gained by consolidating global activities. This suggests that high yield has undoubtedly gone global. And why shouldn’t it? Companies are competing globally, and where their head offices are located matters less than ever.
  • We haven’t hit the bottom: Stephen Dulake, JP Morgan’s Head of Global Credit Research, described the two requirements for a sustained rally in high yield as universal bearishness and sufficient risk transfer. When I combine all of the anecdotes, whispers, numbers and rumours circulating in the market, I believe that the market is bearish enough. However, this bearishness has stemmed from losses in the US in the past year, where most credit fund managers have suffered double-digit losses. Whether they have capitulated is not clear. The people I spoke to still hoped for a rally and were pleased that one occurred during the week and hoped that it would continue – the opposite reaction of someone who was short or underweight market benchmarks.

    Even if people had wanted to take an underweight position in recent months, liquidity conditions would have prohibited this. Liquidity is worst in low-quality credit, and as funds have flowed away from this sector in recent months, high-yield investors’ ability to reduce exposure to low-quality credit in proportion with high-quality credit has weakened. I believe that the mantra “sell what you can, not what you should” will come back to haunt some investors, and any resultant rally this year is likely to be short lived, with cheaper assets staying cheap and more expensive sectors rallying. Unless we see a substantial improvement in global growth prospects, I fear the market will need to fall lower before we can see a sustainable rally.

  • Worldwide woes: Delegates shared common worries: Chinese growth, US politics, Brexit, European banks, energy prices, corporate debt defaults and the credit cycle were all discussed at various points. However, macroeconomics don’t dictate investment outcomes. Warren Buffett bought stocks in 1942 on the day that the news headlines stated: “US losing the war”. The market rose that year.

    Investing is all about perspective, timing, and sizing. High-yield credit markets may not have bottomed yet, but history tells us that investing now, with spreads above 700bps, will very likely generate positive returns on a three-year horizon.

  • Corporate America is in defence mode: Stressed issuers are not the only companies exercising caution. Sectors of the market that are still performing well are similarly tame. The autoparts sector is a case in point, where unprecedented margins, technological developments and new consumer trends, such as safety and sustainability features, should be driving businesses into a new era of growth. The sector is also benefiting from rising consumer spending, low oil prices and even lower commodity prices. However, ask them about their plans and there is very little mention of leveraged M&A or shareholder-friendly activity such as debt-funded buybacks and special dividends.

    Instead, these companies are sticking steadfastly to their free cash flow, favouring the preservation of investment-grade credit metrics to please debt markets instead of shareholders. It’s likely that they appreciate that current market conditions are unlikely to persist. In this context, the concept of raising debt as a B- or even CCC rated issuer for corporate activity seems uneconomic. Could this be the end of a CCC credit rating as a passing grade for debt-funded expansion or acquisition? I wouldn’t mention it to private equity firms.

These discussions provide a good understanding of consensus market views and sentiment as we progress into 2016. Since I returned, events have continued to unfold – eurozone monetary policy has loosened further and the oil price has inched higher – and may influence the broader themes highlighted in Miami. Will such considerations direct our investment decisions?

We continue to favour higher quality US high-yield issuers, particularly in the basic industry, automobile and auto-part sectors, where companies with solid, improving credit fundamentals have sold off with the oil price. Indeed, for some of these companies, cheaper oil is a tailwind. Combined with exposure to the resilient US consumer, this market seems attractive compared with European high yield, where a relatively higher exposure to banks and the lack of an illiquidity premium on smaller corporate issuers make us cautious given the current valuations.

Most importantly, the decision about US versus Europe is now a bottom-up one, reliant on the dynamics of industry sectors and individual companies. More issuers have larger global footprints than ever, seek financing in multiple currencies and compete with each other regardless of their domiciles. Since the inception of our team in 2010 we have argued that credit investors need to adapt to this change, as investment silos of the past, based on geography, amplify investment risks rather than mitigate them and constrain the range of opportunities available.

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Fraser Lundie, CFA Co-Head of Credit and Senior Credit Portfolio Manager Fraser joined Hermes in February 2010 and is Co-Head of Credit and lead manager on the Hermes range of credit strategies. Prior to this he was at Fortis Investments, where he was responsible for European high yield credit. Fraser graduated from the University of Aberdeen with an MA (Hons) in Economics; he earned an MSc in Investment Analysis from the University of Stirling and is a CFA charterholder. In 2017, Fraser joined the board of CFA UK, a member society of the CFA Institute. Having previously featured in Financial News’s ‘40 Under 40 Rising Stars of Asset Management’, an editorial selection of the brightest up-and-coming men and women in the industry, in 2015 Fraser was named as one of the top 10 star fund managers of tomorrow by the Daily Telegraph. In 2016, Citywire Americas named Fraser number one in their global high yield manager review, and InvestmentEurope and Investment Week both named the Hermes Multi Strategy Credit Fund top global bond fund at their respective 2017 Fund Manager of the Year Awards. CFA® is a trademark owned by the CFA Institute.
Read all articles by Fraser Lundie, CFA

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