Developed market economies have adopted monetary policy tools that have kept government yields at historically low levels, while the low yields in core sovereign and high grade corporates leave scant returns for investors.
Yet there is more to lose than win in this part of the market, given the potential for higher interest rates or higher inflation in the medium term.
Elsewhere offers better deals, however. Although credit markets have been beset by high volatility and wide spreads, core European high yield, peripheral European investment grade, emerging market credit and global financials debt provides an attractive universe.
Europe’s larger economies are teetering towards recession, aided by political dithering over a solution for the debt crisis. If policy intervention to prevent large sovereign default is successful, then we see significant potential in many of our favoured investment areas.
A combination of supra-national, central bank and government intervention will prevent major defaults in the medium term – there is no other alternative but to find a solution.
The more pertinent question is that of timing. If policy makers joust between themselves for too long, the recession becomes longer and deeper as debt markets continue to seize up.
However, if they act quickly and in concert to provide a long-lasting resolution, this may prove to be a short-term growth interruption.
In either case, we feel that many areas of credit are undervalued as market pessimism sweeps aside positive fundamentals at the corporate level – at least for now. Such negative sentiment combined with heightened volatility creates buying opportunities for the canny fixed income investor.
Opportunities abound
One such opportunity is in the High Yield market, where record defaults are being factored in. In 2008, global default rates peaked at 11.3% and as of November 2011, they are at 1.8% .
Current spreads are implying peak default rates each year for the next five years. Our view is that default rates will remain low, as balance sheets are stronger and the majority of corporates have already extended their short term funding, reducing refinancing risk.
Emerging market corporates also look good value, and are growing rapidly. These companies rely more on capital markets funding and less on bank financing. The economies remain on a growth trajectory despite the recent market weakness.
While any slowdown in the US and Europe will have an impact, its effect will be reduced as these regions increasingly trade with each other. This presents an opportunity for fixed income investors to diversify their credit and geographic exposure within emerging economies. Emerging market business governance and oversight are also improving, enabling a higher degree of confidence in their operations.
Lastly, financial institution debt, which still constitutes a significant proportion of global issuance, is better capitalised than before the 2008 credit crisis and loan quality has improved significantly.
The complexity surrounding future individual recapitalisations and breadth of capital markets instruments arising from a fluid regulatory environment has led to significant mispricing of risk in many areas, offering a great set of investment opportunities.
The fear of systemic financial market weakness has led to attractive valuations in higher-quality credits.
Despite market gloom, selective fixed income investment should pay handsome dividends in the medium term. High-quality corporate cashflows support instruments paying substantial income, which are likely to see significant capital appreciation.
Volatility, if you know how to roll with it, creates opportunities.
