By Hamlin Lovell, NordicInvestor
How can investors generate income without taking on greater credit risk, interest rate risk, or the lower liquidity associated with private debt strategies?
The dividend yield on equities is now higher than for corporate credit in Europe, but clearly equities are several times more volatile, and dividends could be cut before coupons on bonds are waived. Cash or short-term corporate credit in non-Euro currencies such as the US Dollar or emerging market currencies offer some yield pickup for those prepared to take on the risk of currency depreciation. But once the cost of hedging back to Euros (or SEK or DKK) is factored in, these yields can easily turn negative, even for higher quality emerging market issuance.
Leverage is one option, which can magnify positive yields into a more meaningful positive return. Some asset managers are now able to obtain leverage at an even lower negative rate than the yield on their assets, thus extracting a positive income. This is not without risks however as the cost of leverage is not always fixed. Repoes are widely used for leveraging fixed income, and repo rates in USD have spiked to annualized rates of 10% in September 2019, according to a Wall Street Journal article. “We are not using leverage for our investment strategies, but believe that some clients in Asia are doing so for their investments in our funds”, says Muzinich credit analyst and co-portfolio manager, Ian Horn.
For relatively risk-averse investors, the benchmark for a low volatility income strategy may no longer be zero but could in some cases be negative to reflect what investors can get on bank deposits. The costs of negative interest rates in Switzerland, Denmark and parts of the Eurozone are now being passed onto customers by some banks in some countries, for deposits above a certain threshold. Funds are not immune from this: “as of September, we have observed certain custodians now charging us for cash held in Euros”, says Horn.
In contrast, investment grade (IG) corporate credit, in Euro terms, still has a positive yield to worst on average, with individual names ranging from slightly negative to slightly positive yields. “Credit spreads on IG corporates are actually close to five-year averages; it is the collapse in underlying government bond yields that has reduced overall yields”, explains Horn.
“Corporate credit strategies that cannot take currency risk can invest in hard currency securities, with hedged yields based on the cost or benefit of hedging back to the base currency. So, in theory, a Swiss Franc bond hedged back to Euros could generate a yield pickup over the local currency yield as a result of the hedging benefit from Swiss Francs to Euros. As interest rate differences are a moving target, it might even make sense to buy a bond that currently translates to a negative yield in the fund’s base currency, in the expectation that the hedging cost might change and result in a future positive yield”, says Horn. “Muzinich does not take currency risk in its funds, and so monitoring these costs and benefits is of great importance”.
Increased corporate leverage and default risk
Notwithstanding increased corporate leverage and some degree of credit rating downgrades within the investment grade space, Horn feels confident in identifying issuers who will not default.
Headline leverage metrics for IG corporate debt have risen, but special factors mean that today’s measures are not entirely comparable with historical data. “Real estate issuance, which really took off three or four years ago, now makes up a significant part of the BBB Euro corporate bond market and is a skewing factor. Net leverage for real estate firms can be much higher than for other sectors given the assets owned by these businesses”, Horn explains. Separately, ‘reverse Yankee’ issuance, whereby US companies borrow in Euros, has risen, partly to finance M&A activity, which allows for synergies and cost cutting. This can therefore be seen as a benign form of leverage. “Every risk profile has a price”, he points out.
“The Euro denominated BBB segment has grown over the past few years and the BBB- cohort alone is now comparable in size to the BB and B markets combined. However, this partly reflects issuer preferences. The compression of credit spread differentials per credit rating reduces the benefit of retaining a higher credit rating, so it may be optimal for companies to have a slightly lower rating”.
The bottom line is, “we do not expect widespread downgrades whilst cash flow and interest coverage remain healthy”.
Cyclicals, the UK and Southern Europe
In Muzinich’s view, there is some spread pickup in bonds that have credit ratings that are seen as vulnerable to downgrades. In the “crossover” zone between investment grade and high yield, bonds rated between mid-BBB and BBB- are seen as being at risk of downgrade to high yield. In particular, Muzinich observes that out of favour pockets of the market offer a higher yield in Euros. “Many investors think in terms of macro stories and have shied away from the UK, Italy, banks, real estate and auto companies, but there are individual names within these countries and sectors that have constructive credit stories. For instance, we saw the tier 2 securities from an Italian bank upgraded to investment grade in July and whilst Italy may be disliked by some investors, there are bonds from leading global brands originating from this country. Meanwhile there are real estate firms that are boosting cashflows through mergers, and others that are deleveraging and reducing loan to value ratios”, points out Horn.
The latest round of QE from the ECB could generate opportunities for credit investors so long as they can access market liquidity. The ECB’s appetite to buy and hold bonds will take liquidity out of the market, which increases the importance of access to primary issuance to deploy significant capital.