It may have been an interesting few years in the global credit market but now is the time to think more about capital preservation.
That’s the view of Paul Causer and Paul Read, co-managers of the Invesco Euro Corporate Bond fund. ‘Given the overall level of yield in the market our mind-set is one of caution as it’s not an environment in which we are going to be buying the riskiest issuers,’ says Causer.
‘We also want to build liquidity, whether through cash, government securities or short dated corporates.’ The trick, however, is the timing. The nature of the market means you can’t simply be sat in cash for the next couple of years as that will leave you with no return, while at the same time it’s clear that over the long term the yields on offer are very low.
‘The default rate is still very low so the fundamentals aren’t awful, but you have the increasing sense that the biggest gains are behind us and that risk-reward is starting to deteriorate,’ he adds. ‘It’s prudent to take some risk but we are not stretching ourselves.’
Top managers in European credit by manager ratio over three years
Having the flexibility to put particular credits in the portfolio on their own merits – instead of being there as a result of ties to particular issuers – is one of the benefits of the approach taken by the two managers who have worked together for the best part of two decades.
It is particularly useful during periods when they feel that risk taking might not be the best course of action.
‘We have the flexibility to pull back to cash and high quality assets, such as government bonds,’ says Read. ‘There is the ability to focus on the best quality high yield issuers, keep the maturity profile quite short, and use some hedging and derivatives.’
This is crucial. ‘It’s central to us that we have the ability to take risk when we see value and pull back when yields are compressed and we don’t find the risk-reward particularly attractive,’ insists Causer.
‘Our process is a combination of a flexible mandate, the willingness to take risk when markets offer value, a strong partnership, and the growth of our analytical resource.’
In recent years the fund’s exposure to banks has been the single largest contributor to performance, which was an investment that the managers started building towards the end of 2008 – and it’s been present in the portfolio ever since.
‘The theme was developed on the basis that the banks would embark on a process of healing that would predominantly be for the benefit of the creditor,’ says Read.
‘We have been favouring the UK banks because we have a deep understanding of them.’
Top managers in European credit by manager ratio over five years
This focus on financials is illustrated by the most recent fact sheet which reveals the top 10 issuers – which account for 26% of the fund – include Banco Santande, Allianz, UBS, BNP Paribas, Banco Bilbao Vizcaya Argentaria, and JPMorgan.
‘Financials is still the clear theme in the portfolio,’ says Causer. ‘Outside of that you could describe it as fairly broad with a sprinkling of credits from different sectors, including the large areas such as chemicals and packaging.’
The feeling is that everything has its price. What is needed, however, is an attractive risk-reward trade off in order to make it worthwhile.
‘We try to emphasise the flexibility of sometimes buying the riskier credits and sometimes the highest quality, yet lowest yielding, credits.’
There’s no doubt that 2012 was a stellar year for the euro corporate bond market’s performance but with valuations reaching expensive levels across many sectors and industries, investors are becomingly increasingly mindful of technical risks.
That’s the view of David Stanley, portfolio manager, euro corporate bond strategy, at T Rowe Price, who suggests that these concerns currently appear to be premature with little evidence of investors reallocating assets away from fixed income and into equities.
‘Navigating through the next phase of the corporate bond market cycle will require flexibility and innovation,’ he writes. ‘Corporate fundamentals remain solid overall, as the default rate remains low and leveraged buyout risks are less of a concern in Europe.’
Seven out of the top 10 holdings in Stanley’s Euro Corporate Bond fund, which he has managed since 2003, are from banking, which is understandable when you consider that this sector accounts for 42.5% of the fund, as measured by industry diversification.
Among the most prominent names in the list are Bank of America, Citigroup and Royal Bank of Scotland. The three remaining non-banking names are Banco Bilbao Vizcaya from the world of insurance, and consumer non-cyclical names Imperial Tobacco and Pernod Ricard.
‘Given that financials account for nearly 50% of the investment grade corporate bond market, it is important for investors to maintain diversified exposure to this sector and consider those companies that are less straddled with sovereign risk,’ he believes.
He also highlights the attractiveness of US banks. ‘As well as benefitting from an economic recovery that is further along in the cycle, US banks tend to have a better funding structure and are less reliant on wholesale funding,’ he explains.
‘Relative to European banks, they have lower leverage on the balance sheet, while US banks’ higher main lending drives more profitable businesses.’
It’s worth pointing out that credit markets displayed great resilience in March during what proved to be a momentous month for all the wrong reasons, argues Chris Bullock, manager of the Henderson Horizon Euro Corporate Bond fund.
‘Although we saw a series of weakening economic indicators from Europe, it was developments in Cyprus that dominated market attention as the country sought to finalise a bailout agreement with the Troika, including recapitalisation of the domestic banking sector,’ he wrote.
The fund, however, underperformed its benchmark due to an overall underweight duration position. ‘Unlike the previous few months of the year, corporate news flow was lighter, with returns driven more by macro headlines and sector rotation,’ he says.
‘The fund benefited from an underweight position in senior banks but this was more than offset by an underweight in Tier 1 and peripheral corporates, both of which proved remarkably resilient over the period.’
Karsten Rosenkilde, manager of DWS Invest Euro Corporate Bonds fund, points out that neither subdued fundamental data nor mixed company earnings figures over recent weeks have been enough to lead to a shift in sentiment and derail the positive returns.
It helped his fund, which mainly invests in corporate bonds that possess a high or even top credit rating, enjoy what he describes as ‘an outstanding month’ during April.
‘We benefitted from our overweight in peripheral names and in subordinated banks,’ he says. ‘We expect the compression between core and periphery to continue over the summer.’
The fund’s largest allocation by country is Francewith 14.9%, followed by the US with 13.9% and Italy on 11.2%. The remaining countries, each of which account for less than 10%, are Spain, the UK, Netherlands, Ireland, Germany, Australia and Switzerland.
Negotiations over the Cyprus bailout – including a controversial proposal to tax deposits of less than €100,000 that was later scrapped – sent negative signals to the markets, according to Jean-Olivier Neyrat, manager of the HSBC GIF Euro Credit Bond fund.
The market’s interpretation of the impact of the Cypriot bailout on financial bonds fuelled volatility on risk premia, but the fund remains overweight on the sector, particularly on insurance subordinated debt, which is seen as a category that offers an attractive yield-to-risk ratio. The fund certainly has a diversified spread of industry sectors.
Banking accounts for the largest share at 34.9%, followed by insurance on 9.9%, communications with 8.5%, energy on 7.3%, 7% in finance companies and 5.2% in sovereigns. It is equally as diversified when it comes to country weightings.
The biggest proportion is the Netherlands with 16.1%, followed by the US with 14.2%, France on 12.5% and Spain with 10.2%. Ireland, Italy, the UK, Sweden and the eurozone each account for less than 10%.
‘In current macroeconomic conditions, the investment grade credit market is still an attractive asset class, as corporate balance sheets are sound and banks continue to reduce their balance sheets,’ he says.
‘The outlook for low growth in the eurozone in 2013 should continue to favour investment in bonds since inflation risk is low.’
Despite continued stress in parts of the eurozone, the credit market tone continues to be set by ample liquidity and supportive supply and demand, according to Henderson’s Bullock, who believes rock-bottom bond yields, anaemic growth and long default rates remain supportive for large-cap corporate bond markets.
However, he believes risks are rising, citing Cyprus being under capital controls, business conditions remaining challenged, and Italy still without an elected parliament. ‘The outlook for global economic data is also mixed, with signs that the US is likely to experience a slowdown in the coming months,’ he says.
‘In light of this, global central bank policy is likely to remain highly accommodative which should be supportive of European corporate bonds.’ It is certainly a mixed picture, agrees Causer at Invesco Perpetual.
‘You have a very strong demand for yield and a favourable liquidity backdrop given the pace at which the Bank of Japan and the Federal Reserve are buying government bond assets and the impacts that’s having on asset prices and demand,’ he says.
‘That’s a positive and another is the aggregate trends in quality. They are not improving but neither do they seem to be deteriorating.’ However, then you have the downside. ‘You have the economic backdrop in Europe seeming to get worse if anything and that may feed through into company results if it continues,’ he says.
‘On a fundamental basis it’s okay but you’re not going to earn much so it’s managing expectations.’
Being adaptable, maintaining a multidisciplinary perspective and keeping a long-term outlook will be important measures to navigate the next phase of the market cycle, according to Stanley at T Rowe Price, who points out that security selection is as much about managing risks and providing downside protection as it is about finding attractive rewards.
‘For active managers looking beyond the benchmark there are a number of opportunities across the full credit universe that potentially can add value to a diversified portfolio,’ he says. ‘A flexible and innovative approach will be key in a fixed income environment where the search for relative value will be found in less obvious places.’