Commentary by Sarang Kulkarni, portfolio manager, investment-grade credit, and Michael Pollitt, head of credit research, Europe

From a medium-term perspective, we expect that the global credit sector to benefit from healthy economic fundamentals. As lockdown restrictions are eased and life gradually gets back to normal, a steady uptick in earnings growth across the world should help to repair the balance sheets of companies in more distressed sectors and drive down the rate of credit downgrades.

The technical backdrop for global credit should also remain positive. While supply is expected to fall away from the highs of 2020 as companies revert to more normal refinancing levels, demand from income-seekers is likely to stay robust as yields from traditional sources, such as government bonds, bank deposits and money market funds, remain historically low.  We should also remember that significant structural demand from expanded central bank asset-purchase programmes will remain a vital backstop for investment-grade credit markets.

For now, capital markets remain fully open to investment-grade issuers and companies continue to run high levels of liquidity to protect against a delay in their recovery. However, if there is a bump in the road, such as a vaccine misstep, then those sectors most sensitive to social distancing could be hit hard. In the worst-case scenario, this could also ripple out rapidly to the broader economy and raise the spectre of a further recession.

We should also consider that the aftermath of the pandemic could see some industries fundamentally disrupted. Bricks and mortar retailers, for example, are coming under yet greater existential pressure as lockdowns accelerate the shift to online. 

Therefore, in a shifting landscape there remains real potential for a recurrence of the differentiation between sectors seen last year if the containment of Covid-19 suffers a major setback.

Little room for error

The key challenge now facing investors is that the global credit market now appears to be ‘priced for perfection’, with little room left for error as spreads return to their pre-pandemic levels.

Credit spreads have tightened since March 2020 volatility

Source: Bloomberg - Bloomberg Barclays Global Aggregate Credit Index – option-adjusted spread (%). Data from 18 January 2016 to 15 January 2021.

Although the global pandemic has caused large price swings and social restrictions continue to impact economic recoveries, the vaccination ramp-up provides a credible pandemic exit. With monetary and fiscal support continuing to dampen risks, the market is now discounting a brisk pace of recovery.

When valuations have been historically at these levels, the credit market has struggled to deliver performance. Often returns have been low and in some cases negative. In other words, it is not a market to reliably generate returns from broad directional calls, or beta.

Investors are often tempted in this phase of the cycle to target areas of the market that provide a shorter-term solution to achieving a higher yield. But, when the correction comes, these sectors can be more vulnerable to drawdowns than the lower-beta sectors. The optimal timing for such a move was arguably six months ago when valuations were less stretched and risk appetite was supported by hopes of vaccine developments and expectations of a further major injection of fiscal stimulus in the US.

The question for investors is how to combine risk mitigation while still capturing upside potential as the recovery gets into gear. We believe the answer is a strategy driven by disciplined security selection.

Keep a sharp focus on issuer fundamentals

The pandemic has created a fertile backdrop for credit strategies based on security selection. When central banks and governments unleashed their huge wave of support in the early stages of the pandemic, not all bonds benefitted equally. A wide dispersion of returns emerged with consumer discretionary sectors such as airlines and entertainment feeling the full impact of social restrictions, while the US technology giants benefitted from them.

Rigorous security selection can still extract value from even the most pressured credits. Heathrow Airport, for example, is an issuer that was arguably in the eye of the storm of the pandemic. But instead of ruling out taking a position, we took a step back to examine key idiosyncratic risk factors impacting the name. We took the view that Heathrow would be underpinned by its pre-eminent position in the UK aviation industry and, when it secured breathing space to recover by successfully issuing £1.4 billion of new bonds in October, we saw an opportunity with strong upside potential. By taking exposure we were able to participate strongly in the market surge that accompanied the positive vaccine trial announcement in November.

Adding value through security selection: Heathrow Airport

Source: Bloomberg. Data from 1 July 2020 to 29 January 2021. Pan Euro benchmark refers to Bloomberg Barclays Euro Aggregate: Corporates Index, in EUR

Heathrow remains well positioned to bounce back further when the UK economy reopens. However, we must remain mindful of valuation, ask tough questions and stay disciplined. Successful security selection in credit, as elsewhere, relies on correctly assessing idiosyncratic risk factors rather than trying to time the overall market.

A differentiated market brings opportunity

Global credit retains its allure as a source of competitive yield in an income-starved world. Despite rich valuations, it also continues to offer valuable secondary benefits, both as a store of attractive total return potential and as a lower-volatility buffer against equity market drawdowns.

Over the course of the uneven economic recovery we foresee, leveraging fundamental research capabilities can be helpful in identifying the opportunities in credit where risk-adjusted returns are most attractive. Given the prospect of increased differentiation across geographies and currencies, as well as sectors, we believe our specialist global credit team, with its rigorous bottom-up investment philosophy and considerable local expertise, is well positioned to extract the latent value that exists in what appears to be a fully priced market.

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