January 2020 Mid Monthly Update – 2020 Vision
For bond investors, 2019 was a good year despite the rise in yields in the final quarter. For TBAM, this is an asset class that have chosen to avoid in our multi-asset Dynamic Fund.
With an objective of UK inflation plus 3% per annum over rolling three year periods, it is not worth investing our clients’ money in assets yielding substantially below inflation. In Sterling terms, an investor would need to take on significant credit risk to get a decent yield above inflation. There are some good, cheap and improving credits out there but they are few and far between and in high yield land, you need to tread carefully not passively.
The US credit markets are the largest and deepest. They represent a good indicator for global credit markets. It is worth looking at the developments within US credit markets in 2019 to offer some thought on what might transpire in 2020.
As thematic investors, we list the themes that we invest in as key long-term drivers of returns. As important are the themes we avoid. One of these is leverage. Due to several years of extremely low interest rates, a number of corporate borrowers have sought to borrow money cheaply. Of course, in a normal economic environment, (post Financial Crisis investors may need to look that up), debt raised would be used for capital expenditure to improve a business or make it more valuable. In a low-yield environment, there have been plenty of yield hungry investors eager to buy those bonds. Unsurprisingly, there has been an explosion in corporate debt outstanding as the graph below illustrates.
Total Outstanding Corporate Debt
However, much of the proceeds of the increase in borrowing was used to buyback stock which in turn elevated the stock price. Good for the key stockholders but more debt, less equity means more leverage which can end badly – GE, for example. In the investment grade space, this has resulted in an increasing number of companies dropping to the lowest investment grade of BBB to the extent that BBB bonds now represent 50% of the investment grade market (see following chart) and investors, especially passive index-based investors run the risk of some becoming fallen angels – the term for investment grade bonds that become junk or high-yield. The fall from investment grade to high yield/junk usually results in a significant price fall.
And spreads have tightened…
…in US high yield:
Source: St Louis Federal Reserve
And also in US investment grade bonds:
Source: St Louis Federal Reserve
So, if you’ve been invested in debt, you’ve probably done well. But most debt represents poor value versus inflation and as we have said here before, most debt trades like commodities – influenced primarily by demand and supply. To get meaningful yields above inflation in Sterling, requires a foray into high yield. Not a natural home for many but nonetheless high yield has attracted many ‘yield tourists’.
In our multi-asset Dynamic Fund, we have a small exposure to high yield, predominantly through credit experts who benefit from exposure to improving credits and either avoid or are short poor credits. The Dynamic Fund has no meaningful interest rate or duration exposure.