Having witnessed the most remarkable turnaround in risk markets over the last 14 months, it makes sense to take stock as fundamentals look to us to be approaching optimal levels. Credit spreads have ground into levels not far from the prior cycle’s tights, and while we remain confident in the underlying fundamentals and a good technical backdrop, recent developments mean that despite this constructive view, our risk appetite has ticked down slightly.
Fundamental conditions for credit could not be much better in our view. Global interest rates look set to stay at historically low levels for the medium term, enabling companies to term out their debt at attractive levels, aided by tight credit spreads which are producing attractive all-in funding rates. The corporate rebound has coincided with a robust set of Q1 earnings, which came before the reopening of many economies and the release of pent-up consumer demand. In addition, there remains an unprecedented amount of fiscal stimulus, with plenty more still to be spent. The consequence of all this is that corporate upgrades are now outpacing downgrades in the US and Europe as company fundamentals improve, and the default rate in speculative grade fixed income is also plunging.
The technical position in credit markets also still looks favourable; demand for income has perhaps never been higher as cash remains a zero-return asset class, an effect compounded by ongoing quantitative easing (QE) programmes that have created a surge in demand in credit markets. As a fixed income investor, what’s not to like?
Well, for one thing, valuations are looking increasingly lofty as they appear to already reflect all this good news. As a result, credit risk doesn’t look quite as attractive to us now as it did a few months ago, and we wouldn’t be surprised if many bond investors looked to book some profits at this point. A quick scan of investment bank strategists shows many are shifting their stance from overweight to neutral on credit, though it is worth noting that writing this in a research note is not quite as straightforward as implementing it at a portfolio level. Of course a lot depends on how much credit risk investors have been running already, as well as the conundrum of what to do with the cash generated by trimming your credit position. Also, due to the considerable momentum of the current cycle it may be that some investors have not yet reached their risk targets and are behind the curve; this cohort may decide they can catch up with the competition simply by not doing very much as others tweak, so for many staying long might be the easier option. However, for those investors who do decide to reduce some risk, the big question is how they implement this. Trimming credit generally goes hand-in-hand with adding more rates risk, and this is far from straightforward currently as inflationary concerns are making government bonds look anything but risk-free.
We have been discussing this problem increasingly more frequently in recent days. In our opinion we believe credit spreads will reach tighter levels in this cycle than they did in the previous one. By that logic there is still room to rally, but with so much good news looking priced in there is a fair chance of a hiccup for risk assets at some stage, whether that comes from tapering, non-transitory inflation, concentration of positioning or something else; having some liquidity with which to buy the dip looks prudent. That said, with fundamentals looking so good and many investors potentially still short of their risk targets we would expect any ‘dips’ to be short-lived. We recall that the big Bernanke taper tantrum dip in 2013 only lasted a month (though plenty of damage was done). In addition, we think the sheer weight of demand for income should put a limit on the size of any price corrections. So trimming risk looks sensible, but not too much.
We remain wary of using rates markets as we are concerned that not all of the inflation we are starting to experience will be transitory. We think it is too early to know for sure, and therefore for us this is not a risk worth taking at this stage. Our base case remains that the 10-year US Treasury yield will hit 2% at some point this calendar year, which from current levels would mean a price loss before yield of close to 4%.
Faced with this situation, we would prefer to increase cash and near-cash by selling assets that have been towed along in the recovery. However, in our view investors shouldn’t be greedy with their definition of near-cash as being nimble is usually key to taking advantage of any short-lived dip. In our opinion ultra-short dated government bonds will do just fine. Within credit we continue to like pro-cyclical names and sectors and we don’t think investors necessarily need to retreat up the ratings curve if they want to trim some risk. The backdrop in both defaults and ratings still looks supportive for selecting winners, provided bond exposure is firmly tilted to securities whose return profiles come mainly from the credit story and not the underlying rates risk curve. Besides increasing cash, one way to reduce risk without retreating up the ratings curve is to dial back the credit spread duration or maturity, making bonds less sensitive to price moves while still delivering some very welcome yield should any pull-back in credit spreads not be that meaningful. Obviously in positive credit stories or sectors spread duration is on your side, but it can still be reduced at the portfolio level.
Our own preferred strategy over the near-term would be to, at the margin, incrementally increase cash while adjusting weighted average credit spread duration lower, which would give a portfolio plenty of additional flexibility for buying any potential dips while staying long credit and targeting income into the strong fundamentals ahead.
