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ANALYSIS: Time in the sun is over for credit

Sander Bus and Victor Verberk, Robeco’s co-heads of credit, are “growing increasingly uncomfortable” about return prospects for the asset class after the strong performance of credit markets year-to-date, they write in a note published on Friday.

“Every blip wider in credit is being absorbed by demand. At the same time, investors have burnt their fingers so often with bearish positions that they have simply given up betting on down markets. That means that potential risks are hardly priced in,” they write.

Take no risk

Over the past few years, credit has benefited from the double tailwinds of easy central bank policy and tightening spreads. However, this blessing risks turning into a curse now since central banks are starting to withdraw stimulus at a moment credit spreads are at all-time lows.

Verberk and Bus have drawn their conclusion: “This is no longer the time to stick your neck out and take risk. With central banks backtracking, investors are less likely to buy on dips.”

Chris Iggo, fixed income CIO at AXA IM, is also facing up to the grim reality that credit outperformance is likely to soon be a thing of the past.

“Valuations are extreme,” he says, taking the opportunity to remind investors it is still not a good idea to fight central banks, even as the effects of their policies will be the opposite of what they were since 2009: exerting downward rather than upward pressure on bond prices going forward.

“It means not trying to extract the last bit of credit compression in European corporate and peripheral markets and it means no longer relying on the central bank “put” to hedge against a rise in default rates in high yield. In the US market, yields have been rising since mid-2016 but if the Fed is to be believed, yields will keep on moving higher,” says Iggo.

Iggo also manages a flexible bond fund which has benefited from the credit tailwinds pretty much ever since it was launched in 2012.

“Being overweight credit relative to rates with a preference for high yield and emerging markets – has turned out to be a winning strategy,” he says. “Going forward, however, it might be a different story. We are at the end of the period of central bank dominance.”

In fact, most flexible bond funds have taken such an approach in recent years, enabling them to deliver solid returns to investors and gather ever more assets.

Moreover, such unconstrained bond funds have been by far the best-selling fund category in 2017 with European fund buyers, topping the sales charts in seven of the first eight months of the year, according to Morningstar data.

High-yield bonds are unlikely to remain the one-way bet they have been for the past 20 months or so (see graph), according to Verberk and Bus. Moreover, the “abundant liquidity” that has driven high-yield returns could turn against the asset class.

“We have seen a massive rise in the issuance of covenant-light structures. This has been a trend in the booming leveraged loan market as well. Covenant-light issuance in loans and bonds provides more flexibility for issuers, but will eat into recovery values once the cycle turns and default rates start to rise.”

It’s a tricky business trying to predict when this will happen. But, as Verberk and Bus put it, “it is enough to conclude that risks are not being priced in at all” to know it is unwise to now be overweight credit risk and/or duration.

Hoping for a correction?

While credit spreads arguably do not anymore adequately compensate for risk, government bond yields haven’t yet gone up enough to make them attractive to investors either. This reality is reflected in Expert Investor asset allocation sentiment data: all developed market bonds are deeply unpopular, and the only fixed income asset class that investors still like is emerging market debt.

Verberk and Bus dismiss EM credit as offering “insufficient spread compensation” for the weaker governance and bond structures, but admit that of all corporate bonds, the asset class is still furthest away from reaching the peak of a bull market (see chart above). However, if you think now is not the time to take risk, EM debt probably shouldn’t be your asset class of choice anyway.

Perhaps the difficulty of identifying attractive fixed income categories is driving investors to one-stop-shop solutions such as flexible bond funds an absolute return. If you don’t know where to put your money, outsource it to an unconstrained fund manager, seems the credo.

But bond managers also seem to now have arrived at a point where they find it increasingly hard to allocate their clients’ money. A market correction would probably make life easier for them. Would you blame them if they secretly hoped for one?

Part of the Bonhill Group.