I like to look at the long term and put things into context. That’s why I find research like the Barclays Equity-Gilt study and Deutsche Bank’s annual default analysis so fascinating. Both are invariably well written with great insights and allow investors to stand back from the noise of markets.
Currently the most common question I get asked is: Are credit markets overvalued? The latest Deutsche Bank study helps to put credit valuations into context. In short, I believe that credit markets remain undervalued relative to government markets.
There are two main factors that determine whether credit is relatively cheap to government bonds: the credit spread over government yields, and the default rate. Over the last 20 years there has been a downward trend in default rates (both investment grade and sub investment grade). Whilst 2020 will represent a year of higher defaults the rise is very modest given the severity of the global downturn and is consistent with the pattern of relatively low defaults. One answer is real yields: over the last 30 years there has been a significant downward shift in real yields, brought about by shifting global savings patterns, lower growth rates in developed economies and government / central bank inventions in markets. What this has meant is that companies have found it relatively easy to refinance and that market forces that push weak companies to the wall are not working to the same extent. Government have become fearful of the economic (and political consequences) of letting market forces rip: in effect, we live in an era of managed capitalism. It seems strange to think, in an age of technological innovation and business disrupters, that old companies still dominate equity indices, especially in Europe, including the UK.
Are we likely to see a reversal in real yields and potentially default rates? Probably not. I think real yields are too low and will rise over time, but they will stay low by historical standards as authorities continue to intervene to keep them low. This means that default rates are unlikely to bounce back either.
So what about the relative price of credit – how has this moved against this background of lower defaults? The answer is that the shift in relative valuation to government bonds has not kept pace with lower defaults i.e. credit bonds have become “cheaper”. In effect investors have not lowered their required “credit spread” in the face of lower defaults. A common argument is that we are not comparing apples with apples and that credit markets have changed a lot – with much higher BBB weightings. Therefore, there has been an implicit lowering of required “credit spreads” – but one masked by changing composition. This argument does not really hold up as the impact of adjusting for index composition is small.
One way of looking at this is by asking what spread is required to compensate for default risk in the BBB sector, assuming a zero-recovery rate. Over a 20-year period the answer, based upon historical analysis, is less than 35 bps. With BBB spread levels at around 135bps at the end of April, that means there is around 100 bps of extra return in this sector to compensate for non-default risk. This is a chunky premium in an era of ultra-low rates.
Now comes the caveat: this does not mean that investors will get a higher return than government bonds this year or next. In my opinion, however, it does reinforce the case for taking credit risk, spreading that risk, harvesting the yield premium and looking at ways of mitigating the impact of default.
Cash, government bonds and currencies
Global cash rates were broadly unchanged, and sterling was a bit stronger on the week.
In the US non-farm payrolls grew 266K in April after a downwardly revised 770K. In normal times, that would be more than respectable, but consensus was for a gain of 1m. The breakdown of the jobs data indicate that reopening played a role in the overall net job gains, with sizeable gains in leisure and hospitality roles although there were net job losses in manufacturing. The unemployment rate also rose from 6.0% to 6.1% against expectations of a fall to 5.8%. That was partly for ‘good’ reasons though, as the labour participation rate increased more than expected.
As expected, the Bank of England (BoE) kept the policy rate unchanged at 0.1% and the planned total government bond purchases was maintained at £875bn. The vote on the latter was not unanimous as outgoing Chief Economist Andy Haldane voted to reduce the stock of asset purchases. The BoE’s forecasts now implicitly endorse a rate rise by Q2 2023, reflecting a more optimistic view on the economy. Nevertheless, on inflation, near-term price pressures are seen to be transitory.
Global government bond yields were lower over the week whilst implied breakeven inflation nudged higher, particularly at shorter maturities. Europe was a bit of an outlier with rates staying the same or going higher. On the curve UK long-dated bonds performed well, reversing some of the recent steepening.
High yield indices hit another 2021 high with spreads narrowing marginally. Supply continues to be strong, especially in US dollar issues. Investment grade credit spreads were again broadly unchanged.
Activity in our sterling credit funds was low. We took a position in a new housing association issue but the focus was mainly on secondary purchases. In our global strategies, activity was higher with purchases of new issues from Tullow and TUI Cruises.
The problem with viewing things from a longer-term perspective is that it takes time to pick up changes in direction. Looking back, I was slow to buy into the low interest rates world of the last 30 years. Conversely, it has really been helpful when looking at credit valuations. Yes, the lower default trends in place could have encouraged more sub-investment grade exposures in our portfolios but we never lost sight of the excess compensation our clients receive for taking credit risk over the longer term.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.