Subordinated financials, high yield bonds and emerging markets still offer relative value in a rising interest rate environment
The market backdrop for income seeking investors has been challenging for several years. Despite recent rises, the overall level of yield available remains low in absolute terms and as a result volatility within the underlying bond market can quickly erode capital. An example of this was the volatility in government bond markets during early February 2018. Higher than expected inflation data led the market to believe that US interest rates would need to rise faster than previously anticipated. As the “risk-free” asset that underpins the pricing of large parts of the financial market the rise in US Treasury yields led to volatility across asset classes. US investment grade corporate bonds for example lost 1.5% in February 2018. (1.8% was due to the volatility in the bond price with income only offsetting 30bps of return.)
Meeting the challenge
We believe that one way for income investors to try to meet the challenge of rising bond yields in this low yield environment is to broaden the potential investment universe to include both bonds and equities in a mixed-asset strategy.
While some areas of the market look vulnerable to higher government bond yields, namely long duration, low yield bonds, there are still some areas that we believe offer relative value. In fixed income markets these include subordinated financials, high yield and emerging markets. We also think parts of the global equity market continue to offer value.
Comparison of Yields across various sectors.
|Contingent Capital (CoCo) Bonds||6.4%|
|Hard Currency Sovereign||4.6%|
|Local Currency Sovereign||4.8%|
|Hard Currency Corporate||4.8%|
|Local Currency Corporate||4.9%|
Source: Bloomberg and ICE BofAML. Data as at 30 April 2018. (yield is yield to maturity and dividend yield)
An area of the market where we have been focused for some time is subordinated financials, in particular banks, where fundamentals remain strong. Today, much of the excess value that was available within this sector has gone. However, in certain cases this part of the market can still be a valuable source of income.
There are two key areas of focus. So-called, legacy Tier 1 bank bonds. These bonds were issued prior to the Basel III accord and so are no longer being issued and indeed banks are typically redeeming these high yielding bonds at their call date. Their replacement in the capital structure, a type of Contingent Capital CoCo Bond known as Additional Tier 1 bank bonds are another source of income. The fundamental quality of the bank is critical with these bonds. Our focus is on large systemically important issuers and we prefer banks with significant retail or wealth management businesses that have smoother earnings profiles. The modified duration to worst (i.e. to first call date) of the ICE BofAML CoCo index was 4.0 at 30 April 2018. This relatively low level of duration helps to mitigate the impact of rising government bond yields.
The overall level of yield and credit spreads within European high yield bonds remains very low, however, there are still some areas of the market where we can find opportunities. This can include new issues that come to market at a premium, or investment grade companies that are downgraded to high yield (so called, fallen angels) that we think are putting the right plans in place to turn their businesses around. Other opportunities can be found within sectors that are currently coming under pressure, but that might still include what we believe are strong companies. An example is the UK retail sector. Changing consumer habits are disrupting retailer’s traditional business models, however, this does not necessarily mean all companies will struggle. Some will thrive. Yields are currently higher in the sector reflecting the additional risk. As at the 30 April, the UK retailers component of the Bloomberg Barclays High Yield (GBP) ex Fins index offered a yield-to-worst of 10.7%, compared to the overall index, which had a yield-to-worst of 5.7%.
Along with strong fundamentals, valuations in many emerging market bonds are broadly supportive. Synchronised global economic growth and increasing global trade provide further support to this part of the market. While rising US interest rates and a higher US dollar can be an impediment to the performance of emerging market bonds, we believe that the additional yield and stronger fundamentals provides a reasonable cushion for total returns.
In what is a broad section of the fixed income market, country/company specific factors can also present opportunities. A recent example of this is South Africa. In late 2017, Cyril Ramaphosa was elected head of the African National Congress (ANC) and following the resignation of President Zuma, President of South Africa. Ramaphosa is widely seen as being able to restore the country’s economy and relationship with financial markets. Both South Africa’s government bonds and currency rallied strongly following his election.
While we can still find relatively attractive yields in the parts of the bond market highlighted above, in many cases at an individual company level the equity yield is higher than the bond yield. Our strategy is to look for companies with attractive valuations, that we believe can sustain profit margins and deliver returns through the economic cycle, and which offer growing and sustainable dividends. We seek companies that we believe are high quality, with attractive franchises, and with balance sheets with a conservative level of debt. At a regional level this leads us to favour Europe over the US. In terms of sectors we think the so-called defensive sectors such a consumer staples and utilities offer limited value. Our preference is currently toward more cyclical areas of the market including energy, industrials and financials where we think valuations are more appealing.
While the ongoing low yields within financial markets continue to present a challenge, there remain opportunities for income that we seek to exploit.The key, as ever, is to ensure that the additional risk one might need to take on, is appropriately compensated for by an increase in yield. This remains the underlying philosophy of our investment approach; we will only invest our clients’ money when we think we are being appropriately rewarded for doing so.
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