Macroeconomic conditions are still very positive. However, many investors seem hesitant, worried that the current phase of economic growth has been long and that valuations are high.
As part of an investment approach focused on absolute returns and involving active, unconstrained investments in the bond market, certain segments remain attractive: US investment-grade bonds, global high-yield via CDS indices and finally AT1 (additional Tier 1) debt issued by European banks.
The current market environment is contradictory to some extent. Economic activity remains strong, with firm, synchronised growth across all geographical zones, and inflation is neither too high nor too low, allowing central banks to take a very gradual approach when bringing their monetary policies back to normal. The kind of synchronised growth we are currently seeing is also quite rare.
Economic expansions do not die of old age
However, despite these fundamentals, many investors appear concerned: the current economic expansion in the US has been exceptionally long – the third-longest in the post-war period, behind those that ended in 1961 and 1991 – and this fact alone is prompting some to believe that a downturn could be increasingly imminent. However, the expansion could still have a long way to run: Fed officials have shown that an expansion has the same probability of ending after 80 months as after 40 months.
Indeed, growth phases do not die of old age, but because of shocks, which are usually exogenous and unpredictable, or because of unsuitable monetary policies. While shocks are hard to forecast, central banks are providing a high level of visibility regarding their monetary strategies. We can relatively safely rule out excessive fiscal and monetary tightening: not only is the current expansion long-lived, but growth rates, inflation and interest rates have also been lower than in previous cycles. Low inflation and wage growth in particular are enabling the Fed and the ECB to take a very cautious and gradual approach to monetary tightening.
Gaining exposure to certain bond segments via derivatives and CDSs
In these circumstances, bond yields are likely to remain relatively low. However, valuation remains a crucial issue after the rally in bond and equity markets over the last few years. Credit spreads are still attractive. US BBB credit spreads are currently wider than the lows seen during the two long expansions that ended in the 1960s and 1990s, by 60 and 100 basis points respectively.
At the moment, several segments of the bond market stand out, including US investment-grade and global high-yield paper via CDS indices. To that list we can add AT1 debt issued by systemically important European banks, whose earnings are continuing to improve as non-recurring expenses decline. These various segments have been delivering good returns for several quarters now and continue to provide an attractive expected return as they have seen little or no change in their carry and roll-down profile. Indeed, valuations of US investment-grade credit bonds and high-yield CDSs today remain at their five-years average, with yields close to 3% (+1% of roll-down) and 6.5% respectively in dollar terms.
We are advising investors to focus on absolute returns, which offer an active and unconstrained investment approach. In this context, derivative strategies make it possible to achieve a higher yield, using carry and roll-down, on US investment-grade credit – in other words, to exploit relative value opportunities, i.e. to identify the best sources of bond returns with no increase in risk. Similarly, high-yield CDSs can help deliver a superior yield to traditional high-yield paper, with lower duration and better liquidity. In the high-yield segment, CDSs are also more attractively valued than the bonds themselves. By actively managing credit and interest-rate exposure, investors can control portfolio risk more effectively.
Christel Rendu de Lint
Head of Fixed Income