Other fund managers have also adopted a more discerning approach when investing on a standalone basis. They have switched into local currency emerging market debt with the attention being on the strongest issuers on a company-by-company or country- by-country basis.
As Dan Greene, head of global consultant relations at Invesco Perpetual, puts it: “Local currency emerging market debt is yielding 5.60% compared to 5.01% in hard currency bonds. Issuance has been incredibly strong this year, with bond covenants and local laws potentially more complicated than in more mature markets. The most important thing is to have strong bottom-up credit research capabilities by EM experts with deep knowledge of the local markets.”
The same applies to high yield bonds, which are trading at record highs and sitting on low returns as witnessed by The Barclays US Corporate High Yield Index recently slipping below 5% for the first time. Another concern is high yield bonds tend to track stock prices more than they do government bonds and if the stock market collapses, they will not offer the same type of protection provided by those government or even investment-grade corporate bonds.
In addition, as Fraser Lundie, co-head of credit at Hermes Fund Managers with Mitch Reznick, points out, even if the markets climb higher, high yield will not rise like in the past because if the bond reaches a certain price the company has the discretion to call it back. This was not such a problem in 2012 when European high yield bonds were trading at 95 cents on the dollar but now that they are at 105, they have reached the ceiling. Another problem is the mispricing of the option risk.
“At 105, a high yield bond trades on the assumption that it could get taken out at any moment by the company,” says Lundie. “However, if there’s a market dislocation because of a macro shock, these bonds have much further to fall than those without the call option.”
“It is very important for investors to look across the full spectrum of credit to see the most attractive opportunities,” says Reznick. “For example, we think credit default swaps are attractive because in many cases they have good liquidity compared to bonds, little interest rate risk and they act as an insurance contract that gives the holder, who pays an annual premium, the right to collect on the face value of the bond should it default.”
Inflation and rate protection
Other instruments making it onto the income radar screen are real estate debt as well as senior secured debt or bank loans which rank top of the capital structure.
“They offer better protection against an inflationary or higher interest rate environment because they are floating rate notes. They are trading at 430 basis points (bps) above Libor which is a good yield for low duration,” says Greene. “Traditional US investment grade credit is at spreads of 120bps while most global investment grade is around 130bps.”
As for real estate and other private debt investments, the window has been pried opened due to banks scaling back activity in direct loans, commercial mortgage lending, social housing, property and infrastructure.
“Pension funds and insurance companies are showing a greater interest in illiquid assets because of the higher return,” says William Nicoll, director, fixed income at M&G Investments. “There is a marked distinction between them and the standard benchmarks such as long-dated sterling which have become quite concentrated. The challenge is opportunities are limited and asset managers have to do more work for every investment.”
There also needs to be more detailed credit analysis because they are not publicly traded. Take real estate debt. “The critical element is that the underlying security is the property,” says Tim Gardener, global head of consultant relations at Axa Investment Managers. “The big questions are the valuations and whether the asset manager has the skills to add value.”
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