By David Riley, head of Credit Strategy at BlueBay Asset Management
Asset returns have been ‘brought forward’ by quantitative easing and zero/negative policy interest rates.
The law of diminishing returns from more central bank liquidity is coming to the fore and greater rewards will be found from identifying pockets of value founded on economic and credit fundamentals.
Ultimately, economic growth is the source of returns on investment and in a low global growth environment, asset returns will be also be low. In our opinion, it is a market environment that will favour value investors with a focus on capital preservation.
US and EM credit spreads are substantially wider than the 10-year average and hence ‘credit break-evens’ (the increase in credit spread necessary to wipe out carry) have also risen, rendering valuations more attractive.
Emerging market corporate and US high yield default rates are projected to move higher (largely reflecting their high commodity exposure), but even excluding the energy sector, EM and global high yield valuations appear favourable relative to the last 10 years.
Focus on fundamental value
The assessment of ‘fair value’ is greatly complicated by the ‘liquidity premium’. Some estimates imply that the liquidity premium may account for a third of the 350bps widening in USHY credit spreads from their mid-2014 lows.
Much of the rise in EU IG credit spreads following the ‘Bund shock’ in Apr/May, may also reflect a greater liquidity premium demanded by investors to compensate for sub 1.5% all-in yields.
A low growth, low interest rate and low volatility environment is typically associated with credit out-performance. However we expect only two out of three, with periods of market calm punctuated by extreme volatility exacerbated by diminished market liquidity.