Articles - Navigating the hard realities of policy divergence

 By Iain Stealey, Fund Manager, JP Morgan Funds – Global Bond Opportunities Fund

  

 Flexibility is critical for piloting the distortions of today’s bond markets, for example the relative valuations causing 10 year US Treasuries to seem high yielding by comparison to the rest of the world. With 10 year Treasuries just north of 2%, their yields are currently higher than approximately 90% of the world’s government debt. In other words, even if Treasury yields go a little higher from here, they are still attractive compared to the rest of the world for a global bonds investor.

  

 These types of bonds are particularly attractive to life insurers, which typically have long-dated liabilities that need to be matched. Longer-dated bonds are also going to be less sensitive to short-term interest rates and driven more by longer-term expectations of growth and inflation , making them well-suited to portfolios during such periods of monetary policy divergence.
 So this brings us onto the question of in this environment, where should yield hungry insurers investing in global bonds be looking for return and income?

  

 The European high yield debt sector may no longer offer particularly ‘high yield,’ but everything is relative. If you compare the modest yields in European high yield to those on offer in other parts of the bond market; more than a quarter (26%) of European government bonds are trading on a negative yield, more than half (54%) of Germany Bunds are trading on a negative yield – with some 23% yielding less than the -20 basis points that marks the threshold for ECB bond buying eligibility. In effect, this means the ECB will have to buy longer dated government bonds, further flattening the yield curve at the longer end.

 European high yield also has solid fundamentals underpinning the sector, outlining the tailwinds bolstering Europe, including falling oil prices, the weaker currency boosting exporters and the stimulative effective of the ECB’s ambitious QE bond buying programme.

  

 Investors reacted strongly to the ECB’s announcement of quantitative easing (QE) with European high yield seeing its largest weekly inflow on record, totalling €1.03bn (2.7% of AUM), in the last week of January1. Since then a steady stream of inflows, as well as strong flows into Global and US High Yield, has provided a positive backdrop and helped the European high yield market to a 2.1% total return year-to-date. 2

  

 However the strong flow picture is by no means the only positive technical driver for European high yield. We continue to see a wave of cash returning to investors from issuer calls & tenders of high coupon bonds, equity claws following initial public offerings (IPO) and rising stars leaving the index. Rising stars is a particularly powerful theme as these issuers are often large, global companies that represent significant benchmark weights, e.g. 2-3% market value2 which is roughly €5-7bn in cash terms.

  

 Following the upgrade, this cash needs to be redeployed by European high yield fund managers. Over the coming months we expect additional high yield names to climb this path to investment grade, which would represent substantial cash requiring reinvestment within our market.

  

 The story is not simply a technical one either. European corporate fundamentals, having battled against anaemic growth, look set to benefit from lower commodity prices, a weak Euro and the uptick in mergers and acquisitions (M&A). Whilst M&A is not always associated with credit improvement, we are at a point in the European credit cycle where deals are primarily being driven by strategic logic, e.g. to take out capacity or help consolidate a market. Hence we have seen a number of transactions involving European high yield companies merging with or being bought by larger, higher quality peers.

  

 Our expectation for persistently low European default rates (we see European high yield market default rates staying just below 1% for 2015) was reinforced by the recent ECB quarterly lending survey, which showed easing lending standards. Two well publicised market concerns, Greece and the energy sector, present a limited threat to European high yield given their low exposure to our market at 1.86% and 0.84% respectively2.

  

 Finally European high yield valuations in today’s low yield world also stack up. Credit spreads are wider today, at a spread-to-worst of 388bps2, than at the same time last year (370bps) despite the strong year-to-date performance. This is due to the cheap valuations in single-Bs, which trade at an attractive spread-to-worst of 533bps, more than double the spread you get for investing in BBs. Understandably people have been cautious to dip back into this part of the market given European growth concerns; however, we think Draghi’s actions will change that.

  

 Whilst the sector’s average credit quality is slowly improving, even surpassing the average creditworthiness of US high yield; differentiation in asset selection is essential.

  

 For insurance company fixed income portfolios we highlight the following considerations:

 When the question on every investors lips is Fed versus the ECB, with two clearly diverging policies from arguably the world’s two most important central banks playing out with uncertain consequences in real-time, it’s important that insurers take a macro-informed, unconstrained approach to the global bond markets.

 
 1 As measured by the JP Morgan Fund Flow report
 2 As measured by the The BofA Merrill Lynch Euro Non-Financial High Yield Constrained Index (HEAD): Euro High Yield Non-Financial, 3% Constrained, 17/02/15