M&G: «Credit Presents Attractive Opportunities»

Richard Woolnough, M&G Investments

Performance suffered in a bear market for credit in 2015, but looking ahead, we maintain our high-conviction view that the US economy will not lapse into recession, writes Richard Woolnough, Fund Manager with M&G Investments.

By Richard Woolnough a Fund Manager of Optimal Income Strategy, M&G Investments

2015 was a difficult year for fixed income markets. Government bond yields were extremely volatile, trading in a wide range, but ultimately finishing the year slightly higher, apart from the short end of the bund market where yields headed further into negative territory. Plenty of ‘risk-off’ episodes kept investors on their toes, such as the potential exit of Greece from the eurozone, concerns over growth in China and emerging markets, as well as the sharply falling oil price.

Credit spreads tightened early in the year ahead of the European Central Bank’s (ECB) QE announcement, but were significantly wider both in investment grade and high yield by the end of the year.

2016 has started where 2015 left off, with markets on the back foot as a result of continued worries over slowing growth in China and further falls in oil prices, which have left many equity markets in bear market territory and led to a further rise in credit spreads. At the same time, 10-year government bond yields have rallied some 30bps in the UK and US.

The US

Despite the recent asset price volatility and talk of possible recession, growth in the US is doing fine, helped by a weak oil price, which has historically been a tailwind for global growth. 

There is no doubting the weak data from the manufacturing sector, but it has been in steady decline since the 1950s, such that nearly 90% of the labour force is employed in services rather than goods-producing sectors. Therefore, the service sector is much more important for US growth and is doing relatively well, despite some softer data recently.

The labour market continues to strengthen and will put upward pressure on wages. Historically, economic cycles have been halted by financial shocks, energy price shocks, aggressive monetary policy and housing bubbles. None of these are in place currently, and we don’t envisage a US recession.

Duration

In this environment, yield curves are too flat and with yields at such low levels, the risk of taking duration outweighs the potential rewards, in our view, even though yields may remain at these levels for extended periods.

Credit

Although we don’t think there is much value in government bonds, we think there are some great opportunities in the credit market, especially after the widening of spreads over the past several months. 

Although fundamentals have deteriorated, with leverage increasing as a result of record issuance, we believe there is great relative value in the USD market. Much of the issuance has been companies trying to finance ahead of a Fed rate move, or linked to M&A activity, which could slow down as consolidation comes to an end in some sectors and as investors push back on any deals perceived as destroying value or harmful to balance sheet health.

And although earnings have deteriorated, this is mainly in companies with a significant share of foreign sales and due largely to the strong US dollar, which has already run a long way.

Domestically focused companies have seen decent earnings growth in 2015. At the same time, the yield gap between the US and Europe should lead to demand for US assets from abroad.

The argument against this, of course, is that a progressively more accommodative ECB could mean a still healthy demand for European assets, since it is very expensive to hold cash in Europe. However, this in turn might lead to more reverse yankee issuance, which is a trend we saw in 2015, with US companies issuing into the euro market at cheap levels.

In USD investment grade, one of our favoured areas is long-dated BBBs, which are trading at spread levels that have only been wider during the height of the financial crisis. And, as mentioned above, we don’t think we are near a crisis.

Within this, we are finding a great deal of value in the telecommunications sector. The sector is quite defensive, but spreads have widened significantly as it is one of the sectors where there has been consolidation and M&A activity, which has meant a lot of new issuance.

In GBP investment grade, we tend also to be focused on BBB rated bonds, but typically in the middle part of the curve. This is because the short end is very low yielding and the long end of the spread curve is very flat, in contrast to the US. Together with concerns over some individual credits, this means we have a relatively low weighting to the utility sector that tends to have a lot of longer-dated issuance.

High yield exposure

We have been slightly underweight in high yield for the past year or so, but we have taken the opportunity to increase this exposure to a roughly neutral position of around one third, given the recent sell-off. Although the energy sector has been at the centre of the weakness, driven by the falling oil price, this has also spilled over to some other areas of the market, given the general ‘risk-off’ tone, leading to more attractive valuations elsewhere.

We remain cautious on the energy sector as we believe the oil price is likely to remain low for some time and default rates in that part of the market will continue to rise.

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