BBB’s the place to be

Within the broader global credit market, John Stopford, Co-Head of Fixed Income at Investec Asset Management, singles out BBB rated credits as the current “sweet spot” in terms of risk and return.

• Credit markets have recovered strongly from the lows seen in March of this year.All grades of credit quality from AAA to CCC outperformed government bonds in the month of July.It is easy to be sceptical about the sustainability of this type of performance, however we believe that over a medium term horizon credit markets continue to offer very good value versus government bonds.
• We particularly like Investment Grade rated credit, and more specifically, BBB rated credits.We think that this is the current “sweet spot” in terms of risk and return within the broader credit markets. Our belief is based on the following three factors – fundamentals, valuation, and technical considerations:

1. From a technical perspective, cash continues to pour into credit funds, attracted by the prospect of good risk-adjusted returns (especially given the poor returns available on cash). We do not see this changing in the short term.

2. In terms of fundamentals, we believe that many Investment Grade rated companies are well positioned; earnings have fallen year on year, but have largely beat expectations. Additionally, many have shown resilience on the cash flow front as companies were able to quickly cut costs ahead of revenue declines.We have also seen strong levels of both equity and debt issuance from Investment Grade rated entities all year.In fact, bond issuance has been at record levels in Europe for non-financial issuers.All of these factors help to shore up the liquidity of the companies and make default a very low likelihood.

3. Meanwhile, valuations for the market as a whole are much less generous than they were at the beginning of the year.BBB-rated European credit is trading at roughly half the level at which it was trading on 1 January.Even so, valuations are well off the tightest levels that we saw in 2007.Spreads have largely just rebounded from the post-Lehman Brothers collapse spread widening, but have not made substantial progress towards the tightest levels of the market.Additionally, Investment Grade bond spreads are pricing in a default environment that is multiple times worse than we saw in the Great Depression, which we feel is much too pessimistic.

• In conclusion, BBB-rated credit is the area where we feel that investors are most overcompensated for the potential default risk given current levels of spreads.