Last updated: 12:16 / Tuesday, 19 August 2014
CIO Comment, Threadneedle

Corporate Credit Strong Excess Returns Are Over, But It’s Still the Best Opportunity in Fixed Income

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Corporate Credit Strong Excess Returns Are Over, But It’s Still the Best Opportunity in Fixed Income

Risk assets struggled in July as the MSCI World index produced a dollar total return of -1.6%. Global geopolitical concerns weighed on sentiment in equity markets, reflecting the ongoing crises in Ukraine and Gaza, while a stronger-than-expected US Q2 GDP print (4% annualized, well ahead of expectations) raised fears that the US Federal Reserve could be forced to raise US interest rates sooner than is currently anticipated by markets. In Europe, idiosyncratic risks came to the fore as shares in Banco Espirito Santo were suspended due to accounting irregularities in some of its holding companies. In contrast to the weaker tone in developed equity markets, emerging market equities (excluding Russia) generally had a positive month, with the MSCI Emerging Markets index up 2.0% in dollar terms. Signs of economic growth stabilization in China helped to lift emerging market equities, as second quarter Chinese GDP growth came in at 7.5% year on year, in line with the government’s overall 2014 growth target.

In bond markets, 10-year US Treasury yields moved higher in July, ending the month at 2.56%, having finished June at 2.53%. However, 10-year bund yields moved lower as some weaker-than-expected sentiment surveys and a below-consensus reading for the harmonized index of European consumer prices for July stoked deflation concerns. In broad terms, emerging market debt was resilient as the JP Morgan EMBI+ posted a dollar total return of 0.07%, but Russian debt performed very poorly as EU ambassadors approved upgraded sanctions towards the end of the month following the Malaysia Airlines tragedy in Ukraine, which has been attributed to Russian-backed separatists.

In terms of our current positioning in our asset allocation model, we continue to dislike core government bonds as we see better opportunities in corporate credit. However, we would highlight that the period of strong excess returns from credit is over and therefore we expect returns this year to be driven by the coupon. High yield had a difficult month in July following Janet Yellen’s comments that lending standards for leveraged loans and some lower-rated corporate issuers had deteriorated. Absent a decline in credit quality, the recent weakness in high yield could be seen as a buying opportunity, and will certainly provide fixed-income-only investors with food for thought, but we are not inclined to add to our exposure in our multi-asset portfolios.

As well as favoring credit, we remain overweight equities (via the UK and Japan) and property. UK equities can no longer be regarded as cheap, but an attractive dividend yield continues to provide support. Moreover, the UK remains an attractive destination for global companies to deploy their surplus cash and we expect M&A activity to continue given that many businesses are reluctant to commit to investment capex. One potential headwind for the UK is political risk, with the Scottish independence vote looming and a general election due in 2015. In Japan, valuations are attractive relative to other developed equity markets and recent evidence suggests that the increase in the sales tax is not creating a major headwind for Japanese corporates. A recent research visit to Japan by our global equities team indicated that the Bank of Japan is relaxed about the impact of the sales tax. Commercial property values in the UK continue to recover and gain support from the lack of new development post the 2008 financial crisis, which has left supply constrained in a number of areas. Perhaps more importantly, the high real yield available from commercial property remains attractive in an environment where bond yields are very low by historic standards.

Opinion columns by Mark Burgess, CIO at Threadneedle Investments.

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