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Fixed income through the perma-frost

Andrew Jackson, Head of Fixed Income, Hermes Investment Management, peers through the gloom, to find encouraging fundamentals and attractive valuations which continue to support opportunities across the fixed income universe, where investors are becoming more discerning about what they are buying within active funds.

Hermes Heat Map: Charting relative value across fixed income

As the weather cools down, we have updated our quarterly Hermes Heat Map (Figure 1) illustrating the contributing value factors in fixed income asset classes.

 Figure 1. Relative-value frameworks and contributing factors

Source: Hermes as at 30 September 2018

  • The data shows us that liquid-credit assets have scored well on a relative-value basis this quarter, with EM credit topping the rankings, and investment grade, hybrids and financials also looking attractive. The outlook for high yield declined relative to Q2, but at a more granular level indicates a disparity in attractiveness; the US looks less attractive (especially CCC-rated instruments) while parts of the European market, in particular longer dated BB-rated assets, look more attractive.
  • Senior financials continue to look relatively cheap, especially in peripheral Europe, while subordinated financials look slightly less attractive after spreads narrowed over the quarter compared to the iTraxx senior financials index, which widened by 59%.
  • In the structured credit space, European CLO (collateralised loan obligation) tranches have continued to move wider, making their valuations more attractive relative to the beginning of the year. Conversely, CLO equity ranks lower this quarter, as equity returns on CLOs could potentially be lower as the higher-weighted average cost of CLO liabilities is not being offset by wider spreads on the leveraged loans on the asset side.
  • Private-credit opportunities continue to offer an attractive return premium over liquid assets, while direct lending and trade finance rank well on a risk-adjusted return basis.

Credit fundamentals

Solid earnings, benign default projections and strong refinancing activity all support a stable outlook for credit. Nonetheless, we have noted a late-cycle feel to recent high-yield primary-market activity, where global jumbo deals were papered over with generous covenants and vertiginous leverage levels. Moody’s published a report in August suggesting that global default rates would finish the year at a below-average level of 2.1% this time next year – close to a nadir of 2%. As per the reports, Europe is expected to lead with a default rate of 1.5% one year from now, compared to 2.7% for the US and 1.7% for Asia.

The fiscal gift of lower tax rates has propped up US corporate earnings even as wage pressures (sparked by low unemployment rates) and rising input costs loom. European corporate earnings were more mixed than in the US. However, firms in Europe appear more focused on de-risking balance sheets than gearing up further to fund shareholder income. EM fundamentals have varied widely for different reasons but at headline level, the rising US dollar has hit all EM currencies – a trend that has flowed through to credit valuations.

Political uncertainty in many countries has also impacted valuations and policy decisions. We see several potential threats to the stable outlook for credit, including: heightening trade tensions initiated by the US, global monetary-policy tightening, further Chinese economic weakness, a strong US dollar, and a higher oil price.

Public credit

Europe leads the way – European high yield is now trading two standard deviations cheaper than US high yield on the back of divergent macro-economic environments and increased political risks in Europe related to the Italian budget. We favour re-allocating some capital to Europe based on the price differential and the lack of convexity in lower quality US high yield.

EM investment grade attractive versus DM – EM investment-grade issuers are well prepared to withstand a period of volatility. But their developed market peers, especially in the US, could be less resilient to uncertainty given the record debt they have racked up to fund acquisitions and perform ‘shareholder-friendly’ behaviour.

Financials on the EU periphery have scope to outperform – Financial-sector performance is very sensitive to geopolitical headlines, and the current environment is generating plenty of opportunities for selective exposure. However, to take advantage of these opportunities, investors must choose both the right issuer and, more importantly, the right security.

Leveraged loans

M&A activity has continued to dominate the leveraged-loan space both in the US and Europe, and investors noted a surge of large deals in Q3. European deals above €1bn totalled about 10% of overall new issuance, for the first time since 2008. Sponsors are increasingly attracted by the flexibility of leveraged loans, which have low duration and can be called at par soon after issuance. Likewise, second-lien issuance is on track for a calendar-year record for volume in 2018 following rising demand.

Combined, the low-interest-rate environment and the M&A splurge has raised leverage: as of September 2018, the average European leverage multiple has risen to 5.4-times – the highest point since the final quarter of 2007 when it hit 6-times. At face value, the rising leverage statistics could, perhaps, signal that the cycle is ending. However, the raw debt numbers should be weighed against the current high level of interest rate coverage. In Europe, for example, average interest coverage is about 4.3-times compared to 2.2-times at its lowest point in 2007, reinforcing the need for investors to closely monitor borrowers’ fundamentals with a focus on their ability to face headwinds such as an interest rate rise.

Structured securities

The CLO market has been running hot with issuance set to breach post-GFC highs this year. Indeed, the high levels of issuance in recent years, coupled with lower volumes of maturing legacy paper, has seen outstanding volumes increase for the first time since the financial crisis. Overall, the ABS deal pipeline remains healthy, with a number of issuances in the offing across core asset types – such as autos and residential mortgage-backed securities (RMBS).

Private credit

Rising defaults continue to weigh on the retail sector while UK loans still offer an attractive yield premium due to uncertainty about Brexit.

Private Lending - Deal flow picked up considerably through the Autumn and alongside a bounce back in UK transaction volumes, pipelines have remained strong in both Germany, France, and, increasingly, Scandinavia. Extra supply, however, has not quelled demand with record fundraisings seeking higher levels of return.

In a new development for this sector, a number of recent mid-market transactions have been inked on a cov-lite basis. In this increasingly aggressive market, success depends on the ability to originate loans while keeping a tight discipline on lending practices. Defaults remain low outside of the UK retail sector, but high levels of liquidity are undoubtedly keeping zombie companies afloat – allowing them to refinance while encouraging weaker loan structures. Given these conditions, recoveries could suffer over the longer term.

Asset-Based Lending – UK and European real estate continues to offer different value propositions that change over time, where a lack of correlation between sub-markets can benefit investors. The UK and Germany are the largest and most liquid European markets whereas assets in smaller countries, or those which do not adopt euro or sterling as the local currency, can suffer significantly lower trading volumes under adverse market conditions. When evaluating risk metrics, lending standards appear to have remained disciplined, with average interest coverage ratios being sufficiently high to provide enough comfort to lenders on a borrower’s ability to service debt through existing real estate rental income.

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