Several of our best investment ideas come from the European markets, where central bank liquidity, above‐trend growth, and weaker currency are powerful tailwinds. At the top of our list, European high yield looks attractive to us.
Europe is at an earlier point in its credit cycle, some already highly‐rated credits may be poised for an upgrade, and the market has little exposure to energy. Yields may seem low, given the low reference rate and higher credit quality, yet spreads are comparable to those in the US on a credit by credit basis.
European high yield continues to benefit from improving fundamentals, meaning that an already higher credit quality market is poised to deliver more rising stars – future investment grade companies that should deliver tighter spreads and higher prices.
Stiffer bank regulation also remains supportive of European financials, where we are happy to lend to banks that, having strengthened their reserves and capital buffers, increasingly do not need the money. Specifically, we like hybrid bank capital debt, although we are cautious of banks with emerging market exposure, and we prefer the securities of banks that have completed their financing needs.
Even with the significant market volatility we’ve seen in German bunds, these areas of the market have remained relatively stable. We are focusing on high quality financial institutions in regions with strong regulatory regimes (such as the UK, Switzerland and Scandinavia), and investing in those banks that are retail-oriented without investment banking divisions (as they are subject to significant litigation risks).
Finally, we like the bonds of peripheral European countries. Many have gone through painful structural adjustments; growth is spreading from core Europe; and yield spreads still have room to tighten, especially as the ECB continues with its purchases into 2017.
We are more cautious with regards to US investment grade corporates, as many are dependent on global demand. Furthermore, continued easy money increases the opportunities for investment grade issuers to re‐leverage. However, continued new issue supply should put negative pressure on spreads, creating a buying opportunity in the long end of the curve.
Finally, given our concern over slowing global growth, we remain wary of the emerging markets. Commodity prices remain a major headwind; the effects of a strong US dollar have yet to be fully
priced in; and the spectre further rate hikes may increase the risks for EM crises.
In summary, one could view the recent confluence of events as being a ‘bond friendly’ development, in that the deflationary impulse from the collapse in commodity prices and the retrenchment across the emerging markets will limit the degree to which the Fed can raise rates.
As long as the Fed is patient and China can engineer a soft landing that bodes well for a credit friendly environment. Volatility will certainly be higher, and capital market prices will have to reflect that. Our overriding theme is to own high quality duration in whatever sectors of the market we find value.