This will probably be the worst but also the best year for bonds ever. Rising interest rates and credit spreads are causing hefty price losses. Inflation is a bond investor’s worst enemy and it is skyrocketing. The fact that interest rates and credit spreads are rising fast is good for bond investors in the long run. Panic and volatility always create opportunities.
Now that the Fed, led by President Jerome Powell (pictured), on Wednesday raised interest rates by another 75 basis points to a range between 3 and 3.25 per cent, it means that TINA - There Is No Alternative - can be declared dead. There is another alternative to equities.
The big question, of course, is when is the time to get in? There are some components in the bond market that look attractive in terms of valuation. The tricky part is that this does require an assessment of the structural level of inflation over the next ten years. Inflation is unlikely to remain at these levels.
Challenge: estimating inflation
Firstly, inflation always measures year-on-year price developments, which means that high prices right now reduce the likelihood that inflation will be high a year from now. At the same time, such a long period of high inflation does ensure that we will no longer have to reckon with annual inflation averaging 2 per cent, but rather 3 to 4 per cent. Central bankers probably like this level of inflation given the high level of debt.
So in the bond market, it makes sense to look at real interest rates. There are few countries in the world where there are currently positive real interest rates. The leading country is China, where the central bank is more like the Bundesbank than the Federal Reserve or the ECB in terms of discipline. There are also several emerging countries with positive real interest rates.
High-yield bonds
Central banks in these countries are not shocked by a bit of inflation and are also used to reacting to it immediately. They did so again this time and started raising interest rates much earlier than the Fed or the ECB. In theory, these very countries should suffer from a strong US dollar, but it is striking how well they are staying put right now. That gives potential if liquidity improves when the dollar turns. Many of these currencies are also solidly undervalued. That is precisely where monetary madness has not struck.
There is another segment that looks more attractive in terms of valuation and that is high yield bonds. The simple rule of thumb I use is that an investor should receive at least an extra fee (the credit premium or spread) of four per cent for the risk run. That risk is mainly permanent loss of wealth. High yield or junk is much more sensitive to credit losses than investment grade bonds. That may seem like a disadvantage, but it is actually an advantage.
Credit spreads
Historically, we have often seen that when there is a sudden loss in an investment grade portfolio - a so-called jump-to-default - a manager does not know quite what to do. These bond farmers assume that loans will be repaid neatly at par. If they are not, they want nothing more to do with them. High yield investors constantly factor in credit losses and know what to do if a company collapses. So now credit spreads are above four per cent, but anyone looking back in history will see that credit spreads tend to overshoot in times of recession.
It seems that a recession is not yet fully priced in. Also, the extent to which declining liquidity affects high yield should not be underestimated. Investment grade companies can always raise money, for high yield companies the window is closed. High yield is cheap, but possibly there will come a time when it will become even cheaper. In that respect, we are at the right time of year. The advantage of a recession is that it increases specific risk and hence dispersion, allowing an active manager to add value.
The quality of high-yield bonds has improved in recent years. In the past, there was always a particular sector or segment within high yield where things went wrong, contaminating the entire asset class. In the corona crisis, it was the BEACH companies, before that the shale farmers. In the Great Financial Crisis of 2008, it was the financials, before that briefly the US car companies and again before that, of course, the dotcoms. This time there is no obvious candidate, although in Europe we could soon be surprised by the energy companies.
Risk: leveraged loans?
The quality of the high yield universe is higher than before. At 51 per cent, the percentage of BB companies is as much as 10 per cent higher than during the Great Financial Crisis. As much as 27 per cent (a record) of high yield bonds are collateralised. As a result, the recovery in the event of a default could reach 55 per cent rather than the usual 40 per cent. Moreover, many companies have taken advantage of low interest rates by financing themselves long-term.
As a result, the risk this time may be on the leveraged loan side. With these loans, interest rates rise rapidly and, in the event of an earnings recession, even the increasingly light covenants are hit. The percentage of BB loans once equalled high yield, but has now slipped to 23 per cent. So that’s where much of the zombie companies are.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is one of Investment Officer’s knowledge experts. His contributions to Investment Officer Luxembourg appear on Thursdays.