We are mindful that investment grade and high yield bonds have been on a strong run from a risk/reward perspective, and in that context we have been looking at our weighting in this area. We have decided to clip back our exposure to European high yield across asset allocation portfolios. But we are also aware of broader market complacency and have been asking ourselves whether a bond sell-off is around the corner and, if so, what will trigger a correction.
Taking investment grade (IG) bonds first, our analysis points to an extended benign outlook, as we see favourable policy conditions with the potent stimulus of negative interest rates, while the economic backdrop is steady, volatility is flat and valuations are worsening but not yet rich.
That said, we do remain concerned about the health of US companies’ balance sheets, where leverage is close to post-2000 highs and interest cover is at post-crisis lows. We expect leverage to continue growing and, while this is not atypical behaviour at this mid-late phase of the credit cycle, we believe it is worth paying close attention to, despite decent corporate earnings growth.
In Europe it is a different story. Leverage in the region has stabilised, with a less extreme build up than in the US, and we expect it to fall this year. Also, interest cover for European investment grade companies is estimated to rise this year and next. However, investment grade is such a global asset class that it is difficult to separate Europe from the rest of the world.
In high yield, corporate fundamentals are improving. We are seeing rising profitability and lower leverage, debt and interest cover, while index duration is roughly half that in European IG. The typical high yield company looks very different today than it did 10 years ago – today’s company is roughly three times the size and of better quality. With the above in mind, after a period of strong performance European high yield valuations have richened and are now fuller than European investment grade. For example, BB-rated bonds in the high yield space are expensive compared to BBB-rated investment grade bonds.
Total returns from high yield over the last 12 months have been strong: at a respective 9% and 11% in Europe and the US, while over 10 years this rises to about 100% in each. Spreads are 80 and 90 basis points away from their 2007 tights in Europe and the US respectively.
So where does this leave us?
On balance, there is nothing obvious to upset the apple cart, but we have nevertheless decided to reduce our exposure to European high yield credit, which seems prudent from a risk/reward perspective. The bull argument for credit markets is that the search for yield continues, with ‘Goldilocks’ conditions of slow and steady growth, modest inflation and ‘easier for longer’ policies with low real rates. However, we are mindful that some kind of exogenous shock could trigger a correction at this point and those potential triggers are many and varied, including more hawkish central bankers, a slowdown in growth in Europe, geo-political upheaval such as a rejection of Japan’s Shinzō Abe, and the US, where President Trump is struggling to pass his fiscal and tax reforms.
The market appears to be assigning a low probability to Trump’s policies being enacted, and we are giving much thought to the potential tailwinds this might create. For US equities, our work last year pointed to a possible 16-17% uplift to equity prices from corporate tax cuts alone (using a rough rule of thumb that a 5% cut in taxes boosts corporate earnings by about 4%). The S&P 500 has increased by more than that despite no tax reductions and growing signs that the cuts will be later and smaller than initially hoped. Economic data in the US is now undershooting weakening expectations, and both soft and hard data are softening perceptibly – leaving us comfortable in our view that US equities are fully valued.
Toby Nangle, head of Multi Asset EMEA, and Maya Bhandari, portfolio manager, Columbia Threadneedle