Credit in focus
Article | 04 May 2017
In an in-depth panel interview on 16 March 2017 we asked members of our Fixed Interest team about the key issues facing corporate bond investors. Here are the highlights of the interview, where the team discuss the opportunities they are currently finding in investment-grade, high-yield and financial bonds, their market expectations for 2017 and how their portfolios are positioned to reflect this.
What’s the fundamental backdrop for investment-grade bonds currently?
MM The fundamental backdrop for corporate bonds has been pretty stable although the commodities sector has been a bit volatile recently. And we’ve had some Mergers & Acquisitions in US telecommunication companies.
The technical backdrop for credit has been supportive, too. There’s been a big demand for income producing assets. In the UK and Europe, central banks have been buying corporate bonds, which has been very supportive. It’s been a good period for issuers. They’re able to issue bonds at very low yields, so I think the technical story is still a good one for corporate bonds.
Maybe the one area where the backdrop is not as supportive is valuations. Sterling investment-grade corporate bonds now yield about 2.5%, but that’s driven by low government bond yields, rather than a reduction in the credit risk.
How does it stack up for high-yield bond markets?
TM Many of the factors highlighted by Michael are at play in the high yield market as well. We have slow but steady economic growth globally which is generally a supportive environment for corporate bonds. And although base rates have started to rise in some areas, they’re still very low by historical standards, which means that you’re unlikely to see a spike in default rates, as companies generally are able to fund themselves at reasonable cost.
There are a couple of exceptions. We have seen a lot of volatility in the price of oil and that underlines that the energy sector is still risky in my view, and likely to be volatile going forward. And then in the UK, issuers in the non-food retail sector are trying to navigate the fall in sterling, and it’s uncertain to what extent they’re going to be able to pass all of that through to consumers.
The financial sector has hit the headlines in recent years, perhaps for the wrong reasons. Is there reason for greater optimism now?
JE Last year wasn’t easy for the sector. Investors were concerned about banks’ exposure to commodities and the commodities sector, and the impact of monetary policies on the profitability of banks. We had fears around the Italian banking system. I could go on, but if we look at the big picture, we can see that the fundamentals are still improving and balance sheets are getting stronger. Banks continue to increase the amount of capital that they have. There is a lot of effort put on banks to clean up the legacy non-performing loans, and we expect to see some progress on this front.
Lastly, I think the profitability environment is improving. We’ve seen management being more optimistic in their profit guidance for this year, and we could even see some rising dividend returns for equity holders.
Where are you finding the best opportunities in high-yield markets currently?
RD A tough question. Over 80% of the Merrill Lynch European High Yield Index is yielding below 4%. We can find opportunities to invest in bonds that yield 5%, 6%, 7% or more in companies that we are comfortable in owning – the key is making sure that we’re being appropriately rewarded for the credit risk that we’re taking. It has become much harder to get comfortable with the risk reward balance of the bonds that we’re looking at.
New issues can offer some additional yield over existing bonds, but we by no means are participating in every new issue. Our main focus is on differentiating between the weaker and the stronger bonds. The opportunity for us lies in having done a good job of credit selection when market sentiment does turn.
How are you currently positioning the Invesco Perpetual High Yield Fund?
TM I think that truly compelling opportunities are a little bit thin on the ground, so I’d highlight three themes. First is maintaining a good degree of liquidity (cash or relatively short-duration government bonds) in the portfolio, so that should we see a generalised market correction, we’ll be in a position not only to mitigate the impact on our existing holdings but also to take advantage of opportunities that arise.
Second, where we’re investing now, a lot of it is in those names where you really feel quite comfortable with the credit risk long term. So, I’d be thinking companies that have an earnings profile that’s bond like and features recurring cash flow – utilities, cable companies, that sort of safer credit. And then, selectively, looking at more credit intensive situations. For example a company that has restructured that we now think has the potential to be more cash generative. As long as you have done the work, fully understand the story of a company and you feel that the company’s positive prospects aren’t fully reflected in prices yet.
Are there plenty of opportunities in the financial sector? How are you positioned in the Invesco Perpetual Global Financial Capital Fund?
JE The picture is improving in the sector. If I look at Additional Tier 1s (the lowest ranked form of bank bond), as of yesterday, the year-to-date total returns have been 3.5% – quite a strong start for this asset class. We have invested in securities that yield 6% to 8%, which is quite interesting versus other parts of the market. We also like the legacy capital securities because they tend to be pretty stable in terms of cash prices, they have decent yields, around 4%, 5%, and a relatively short duration as banks have to basically take those out and replace them with new types of capital securities. The fund can also have up to 40% exposure to equities. We currently have 20% allocated to a select group of European bank equities, which we think could be interesting return stories.
Given your overall outlook, how are you positioned in the Invesco Perpetual Corporate Bond Fund?
MM It probably comes as no surprise we’re defensive on interest rate risk. We are finding some opportunities – probably our preferred sector is financials. There are a number of banks, issuers that we like where you can still get some income and don’t take too much interest rate risk. We’ve been favouring US corporate bonds over sterling corporate bonds for some time. In the US, the additional yield corporate bonds pay over government bonds has not been squeezed by central bank buying, but also US treasury yields are at record highs versus UK Gilt yields. This means you get a pick-up in yield from both the credit component and the government bond component of the bonds return. Overall, we’re trying to be defensive on the interest rate side, keep a reasonable amount of liquidity in the portfolio and to pick up some income where we can without taking too much risk.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
The securities that the Invesco Perpetual Corporate Bond, Global Financial Capital and High Yield funds invest in may not always make interest and other payments nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity for the securities in which the funds invest, may mean that the funds may not be able to sell those securities at their true value.
These risks increase where the funds invest in high yield or lower credit quality bonds and where we use derivatives.
The funds have the ability to make use of financial derivatives (complex instruments) which may result in the funds being leveraged and can result in large fluctuations in the value of the funds. Leverage on certain types of transactions including derivatives may impair the funds’ liquidity, cause them to liquidate positions at unfavourable times or otherwise cause the funds not to achieve their intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the funds being exposed to a greater loss than the initial investment.
The funds may be exposed to counterparty risk should an entity with which the funds do business become insolvent resulting in financial loss.
As the Invesco Perpetual Global Financial Capital Fund is a theme-based fund, which only invests in fixed interest and other debt securities and shares of banks and other financial institutions, investors should be prepared to accept a higher degree of risk than for a fund that is more widely diversified across different sectors.
Where Rhys Davies, Julien Eberhardt, Michael Matthews and Thomas Moore have expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.
For the most up to date information on our funds, please refer to the relevant fund and share class-specific Key Investor Information Documents, the Supplementary Information Document, the ICVC ISA Terms and Conditions, the Annual or Interim Short Reports and the Prospectus, which are available from the literature section.