WHY IT PAYS TO CLIP COUPONS
MAY 14, 2018
A rising rate environment means the majority of fixed income investors’ return in 2018 is likely to come from carry or yield and not from price appreciation. Brandywine Global's Brian Kloss sees careful selection of higher yielding securities as the key for returns and protecting valuations.
Two of the biggest risks in 2018 come from the interest rate sensitivity of high quality instruments and from the impact of tightening on US high yield debt. However, a 10-year government bond is going to have much greater interest rate sensitivity than a corporate bond that matures in 2020 or 2021. While assessments from our proprietary models show U.S. high yield debt is around fair value after massive spread compression between 2009 and now.
Furthermore, it is our view that in 2018 the majority of potential return is going to come from carry or yield and not from price appreciation. So, this might not be the best time to dial down exposure to high yield. However, debt issued by higher leveraged companies is at risk from downgrades or rising defaults as rates rise. Therefore a move up in quality and taking a more conservative and defensive stance looks sensible. Security selection will be very important.
In selecting securities, we see business models that have strong management teams, significant asset protection and the ability to weather the next recession as attractive. They are even more attractive where our fundamental analysis shows the debt issued by these companies to be worth a BB credit rating, when the official rating is only a single B.
An added uplift in the high yield space is the potential for a fairly robust mergers and acquisition market. It is our belief that a lot of investment grade companies will be looking to acquire assets at below investment grade companies with good balance sheets. Steel companies, healthcare companies and energy companies are all likely targets. Here, spreads will come down for such bonds once a merger target is announced.
Another opportunity comes from a trend we have observed where lower quality credits do well in the first part of a tightening cycle. This is significant as we expect the normalisation of rates to be a very slow process; we are of the view that there will be only three rate hikes this year and not four. Furthermore, global growth is still at 2-3% and this is a conducive environment for credit instruments. While tax cuts in the US probably means that small caps and more domestic focused companies can do well. Later in cycle as you move towards the likelihood of a recession the risk grows.
Author:
Brian Kloss, JD, CPA
Portfolio Manager
Originally Published at: WHY IT PAYS TO CLIP COUPONS
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