27 July 2017
For years now we have become accustomed to solving our growth problems by layering on more debt. However as the financial system experiences an ever increasing debt burden, the productivity of each new dollar of debt declines. Albert Einstein once said, “We cannot solve our problems with the same thing we used when we created them.” Today’s central bank policies, combined with a meaningful increase in total global debt, will likely lead to a continuation of the problems of lower growth and a persistent lack of inflationary pressures.
This shouldn’t be viewed as a conundrum that can’t be overcome by investors in global investment grade credit. It does mean, however, strong fundamental research, combined with an understanding of other key drivers of performance are required to capitalise on the opportunities in a low yield environment.
Central banks matter
Central banks have had a profound impact on markets. Investors have experienced negative yields in Europe and historically low yields in many countries around the globe. These have contributed to an environment of lower volatility that has led to complacency and makes relative value discussions appear less relevant. However, investors should pay particular attention when central banks such as the Federal Reserve and the European Central Bank are taking steps to reduce liquidity by altering the rate of bond purchases. As the chart below demonstrates, there is a high correlation between total central bank purchases and risk premiums of investment grade credit.
US central banks purchase and credit spreads variation
Source: National Central Banks, Citi Research, Yield Book
The above illustrates one of central banks’ key challenges today: figuring how to exit their non-traditional policies without upsetting the balance they have worked to achieve. Despite recent talks of “tapering”, up to this point they have generally been supportive of markets and adopted policies to counter periods of higher volatility. While we shouldn’t anticipate they will abandon these tactics wider spreads in credit are possible. Our conclusion is that while central banks continue to provide support to minimize financial instability, investors can remain confident adding to credit when risk premiums increase, while still resisting the urge to add risk when credit spreads offer limited opportunity.
Historical trading relationships are not enough
The credit curve for a given issuer represents the return above the risk free rate expected by the market for a series of maturities. For instance, the market might ask for a 50bps spread to lend money for 3 years, 75bps for 5years and 85bps for 7 years. Studying credit curves to determine the most attractive risk reward maturity for an issuer has traditionally been an additional source of alpha. But basing investment decisions solely on historical trading relationship can be an issue as in recent years historically reliable correlations have changed, impacted by the general chase for yield.
This has resulted in more uncertainty and made investing more difficult. It also highlights the importance of reducing this uncertainty through a well-established investment process that includes strong fundamental analysis to fully understand the structures and credit risk of issuers across various maturities and instruments.
Using fundamental analysis, we have found investment opportunities in the US credit market in longer dated utility holding company paper. The higher quality nature of these issuers, combined with their multi-tiered capital structures, provides opportunities for price appreciation and additional yield. Having a disciplined process to add to names such as Anheuser-Busch InBev when credit curves approach the wider end of recent trading ranges has proved beneficial.
Fundamentals – they still matter
We continue to gain confidence from the fact that US corporate fundamentals have been improving, driven by;
- the strength of 1Q17 corporate earnings,
- stronger commodity prices year-on-year,
- a weaker US dollar,
- relatively easy comparisons given 1Q16 weakness;
- and improving sentiment from issuers’ management teams.
Although there is still a high degree of uncertainty regarding future deregulation and tax reform, any progress along those fronts will provide additional upside for investment and productivity. Although leverage remains elevated and interest coverage has been declining, we are encouraged by the recent improvement in EBITDA and revenues across investment grade credit.
EBITDA growth of S&P 500 companies ex-financials
Debt / EBITDA of S&P 500 companies ex-financials
In today’s low yield environment it is important not to “reach” for yield where fundamentals aren’t supportive of pricing. Utilising our global credit capabilities allows us to continue to uncover opportunities in multiple markets by questioning the status quo. Understanding the opportunity set is always critical but particularly true in a low yield environment. Where the pathway to negative returns today is much shorter, without the traditional yield fixed income investors were accustomed to collecting prior to the GFC. It is important we weigh factors across credit markets including, central bank involvement, risk premiums, yield, as well as industry and issuer fundamentals, before allocating capital in a world where significant debt burdens and non-traditional monetary policies have resulted in asset price inflation and skewed risks.