The “low for longer” rates story is itself getting longer and longer. Which asset class is poised to benefit most? While we expect High Yield will provide the greater returns over the next 3 years, we believe crossover credit is best positioned to benefit from the ECB in the near term.
When Mario Draghi speaks, people look for blue ties and bazookas, but instead his decision to keep the status quo for longer has pushed the bund yield to record lows and the US 10-year further down toward 2%. Draghi extended the time frame for rates to be kept on hold until mid-2020 (previously: end of 2019).
Draghi now hints that the next move in rates is more likely to be down than up, and there’s “considerable headroom” for further QE. In the US, the economic cycle is the longest on record, but the yield curve is now inverted. Forecasters had continuously pushed back their rate hike expectations. Now the odds have risen for a rate cut instead.
Investors flock to bonds, but where’s the positive yield?
After Draghi’s speech and disappointing macro figures, investors fleeing to safety encounter a market with negative yields in $11 trillion of government bonds, back to levels last seen in 2016. This is up around 20% from 2018 and accounts for about 20% of outstanding bonds.
A massive amount of money is mandated to invest in fixed income assets. The managers are desperate for positive returns. The “search for yield” phenomenon that has prevailed in recent years remains strong to this day.
Are equities the answer? No, as they are way too volatile for Fixed Income investors. We have often argued that low growth (but not recessionary) is what keeps corporate bonds in the sweet spot, in contrast to equities.
In spite of the long expansion, the US treasury curve is close to inverted, a signal of investors’ worry. In Europe, inflation expectations are below target, manufacturing has slowed, and GDP growth expectations have been revised downward.
Why is crossover credit ideal for resilient, positive returns?
Credit in the BBB and BB ratings buckets (= crossover) fit attractively in between the low-yielding safe assets (sovereigns and A-AAA IG corporates) and the high-yielding, but riskier, single-B rated corporates. The negative yields in sovereigns, also seen even in some A-rated European IG corporate bonds, pushes demand higher for the BBB bucket, in particular.
Going fully into High Yield is not an option for those who have a mandate for the safety and stability afforded by government bonds. Conversely, crossover credits are more resilient than single-B High Yield bonds, along with much less downside risk if the market turns ugly.
We also like the diversification benefits of getting into Nordic credits. It’s important to note that the correlation between Euro IG, HY and Nordic credits is not as strong as some might think, so diversification, even within Europe, spreads the risks. For example, Nordic credits have avoided contagion during weaker periods in Euro credit.
Even after strong returns, spreads still attractive
In spite of strong returns year-to-date, especially in recent weeks, the spreads in Euro IG and HY have not tightened dramatically and remain attractively placed above the median level (median since 1999). Historically (1999-2019), IG spreads have been tighter than current levels 56% of the time (BBB rated) and HY spreads 57% of the time (B rated).
The more dovish stance by central banks has led to very strong demand for bonds, with fund inflows reaching record levels in May. As the central banks’ next step seems to be in the direction of lower rates, duration is no longer as big a fear as it was a year-ago. In light of the prospects for rates to remain low for longer, the duration of the Evli Corporate Bond Fund is back up to over 4 years, for example.
At a time like this when neither the safest nor the riskiest assets are ideal for the short-term, we believe crossover credit is a suitable place to park for a resilient and positive yield.
Text: Mikael Lundström, MSc (Econ), Chief Investment Officer at Evli. Mikael has invested in the European High Yield market since it’s birth in 1999 and has been the portfolio manager of Evli Corporate Bond fund and Evli European High Yield fund since launch. He holds a Morningstar Analyst Rating for his funds.
This article has been published on June 14th, 2019.
Evli is a pan-European credit specialist that has proven its ability to select the right credits, boasting an excellent track record across several fixed-income asset classes. Evli offers three funds in the Euro crossover universe: Evli Corporate Bond, Evli Nordic Corporate Bond and Evli Short Corporate Bond. In emerging markets, the Evli Emerging Markets Credit Fund also invests in a mix of IG & HY.