These are challenging times for income investors. Interest rates are at a record low, some $14 trillion in debt globally trades with negative yields, and companies have cut dividends to preserve cash, with regulators compelling banks to do so. The Covid-19 shock to the global economy has complicated the risk equation, so it is important for investors to be active, diligent, and creative about sourcing income.
Global 5Y/5Y Rates Show `Lower for Longer’ May Persist
Source: Macrobond as at 2/9/2020
How has your perspective changed?
Ariel Bezalel (Head of Strategy, Fixed Income) said coming into the year he was cautious about corporate credit and had significant holdings in AAA-rated US Treasuries. After the March-April selloff, he shifted more into investment-grade (IG) credit, where valuations were attractive and central banks provided ample support. He added very selective positions in emerging markets and in high-yield (HY) credit and maintained his allocation to triple-A rated government debt.
Alejandro Arevalo (Fund Manager, Emerging Markets) believes the Covid-19 crisis highlighted the importance of differentiating among emerging markets (EM), as Asian countries fared better than Latin America. Investors have been returning to the asset class since the March-April selloff, which he said reflects improving economic data, some countries’ willingness to undertake structural reforms and the ability of some EM economies to reduce dollar-denominated debt.
Luca Evangelisti (Fund Manager, Head of Credit Research) said that unlike the global financial crisis (GFC) when banks were the problem, today they are a key part of the solution in helping the economic recovery. The sector’s balance sheet, funding and capital positions have strengthened considerably over the past 10 years, and regulators are easing off after several years of increased scrutiny. As a result, most banks are in a good shape to absorb current shocks.
Talib Sheikh (Head of Strategy, Multi-Asset) sees an income challenge as policymakers continue to squeeze yield in every asset class as they commit to keeping interest rates low coupled with unconventional measures. In response to this problem, Talib is thinking more flexibly about the income investment universe and being more focused about positions — buying bonds or companies that are well understood rather than the index.
Where are the opportunities?
Ariel says the IG market is well-placed to weather the current economic crisis, while the HY market is challenged because of heavily levered companies. In IG, his focus includes defensive sectors such as supermarkets and the odd cyclical company in the event of a vaccine, while in HY it is defensives such as telecoms and pharma. Ariel emphasises that a disciplined approach is necessary in credit because the economic outlook remains difficult. In sovereigns, he has rejigged positioning a bit, moving further out on the curve to 30-year Australian government bonds and 10-year Chinese government bonds.
Alejandro is constructive EM; spreads are looking attractive relative to history and against other asset classes as loose monetary policy has pushed rates in developed markets to historical low levels or even negative. In hard currency EM assets, he prefers corporates over sovereigns because of better risk-adjusted returns, particularly in telecoms, utilities and protein. In local currency, he also likes Chinese government bonds. He highlights the low correlation with global rates and faster than expected recovery.
Luca said the outlook for banks has moved this year from stability to uncertainty as Covid-19 took hold but then quickly to one of more comfort, given the strong fiscal and regulatory support. He is more confident in selectively investing in the lower end of the capital structure, which currently offers very good income opportunities.
Talib notes that equities have had a difficult time due to dividend cuts, but this may be temporary. With unprecedented support from central banks and governments and decent economic growth equity income may be more appealing next year as dividends return. He sees value in selective HY corporates and asks whether dividend-paying value stocks will begin to recover.
How about the risks and how to manage them?
Ariel says government bonds “worked wonders” in March and April, and he emphasises the importance of being flexible and manoeuvring across the fixed income universe to find the best opportunity for the economic environment.
Alejandro says while dollar strength could become an issue again in EM, he does not expect widespread defaults, rather isolated problems in smaller economies and frontier markets. He has reduced risk ahead of the US presidential elections and notes a second wave of Covid-19 is a worry but expects a more targeted approach that may limit the impact in the economy.
Talib is watching real interest rates, currently around negative 100 basis points, a multi-generational low. Negative real rates have been the focus of policy makers and have helped drive the recovery, he observes, and rising real rates if driven by falling inflation expectations would cause a rethink of asset allocation.
Luca says financial credits are a broad sector that do not necessarily move in unison even within the capital structure of a single bank. This provides opportunity to manage risk in addition to more traditional hedging instruments.
Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.