International comment - Credit will prove savvy choice for investors

Credit where credit’s due
John Stopford, Head of Global Fixed Income at Investec Asset Management, identifies how credit could prove a savvy choice for crunch-weary investors

• The credit crunch has resulted in the forced selling of government bonds
• We believe Central Banks are not fully engaged in stabilising the situation
• In our view the sell-off has created exceptional value in investment grade credit and the better quality high yield issues
• We believe that we are entering the sweet spot in the cycle for credit when high yield tends to out-perform equities for a number of years
• Risks remain, but investors should be well compensated for them and there are a number of reasons to expect the risk to be overstated
• In our opinion, it is now time to build exposure to corporate bonds and high yield at the expense of equities and government bonds

The last 9 months have been a torrid time globally for credit investors. The subprime debacle has undermined the value of credit ratings and spread contagion throughout the debt market. Markets for securitised products have ceased trading, banks have become unable or frightened to lend and leveraged investors have been forced to dump non-government bonds regardless of the prices they can get for them.

Forced selling has overwhelmed the normal functioning of markets, which has exacerbated mark-to-market losses and further undermined risk appetite, creating a downward spiral that risks financial meltdown. Fortunately, policymakers, especially The Federal Reserve, have shown an increasing willingness to do whatever is necessary to short-circuit this vicious circle.

As a result, the credit crunch may be entering a new stage. Uncertainty will remain high, but the dominant driver of markets should begin to shift away from liquidity-driven panic towards a greater focus on the underlying fundamentals.

In a normal cycle, we would now be approaching the sweet spot for credit, a prolonged period when corporate debt does well against equities.

As the chart below shows, from the beginning of both of the last 2 recessions the return from investing in High Yield bonds beat the return from buying equities over the subsequent 4 years.

 (Click here)

Source: Investec, Merrill Lynch HY Master, MSCI US Equities

This might seem counter-intuitive. Surely recessions are bad news for lower rated corporate bonds and recoveries should be great for equities. Yes, but recessions are also bad for equities and even though defaults rise, yields typically rise in advance to compensate for this. In the post-recession bounce, equities can do well, but corporate bonds benefit from both high yields and falling default rates.

This, however, isn’t a normal cycle. At least not for investment grade bonds, which thanks to the credit crunch have moved beyond pricing in a weak global economy to pricing in economic Armageddon. As the second chart shows, the yield pick-up over government paper offered by these bonds is at a multi-year high, well above what was available in the last recession. Better quality high yield bonds are also becoming increasingly attractive. Even as credit quality worsens, investors are being over-compensated for likely defaults.

 (Click to enlarge)

Source: Merrill Lynch

Only the lowest rated CCC bond issues appear to be priced for a more normal cyclical downturn, in line, it would seem, with the stock market. In our opinion, bonds rated between single A and single B, on the other hand, are likely to out-perform cash deposits, government bonds and equities materially over the next 1 to 2 years.

Senior bank debt looks particularly cheap. The Federal Reserve-sponsored rescue of Bear Sterns demonstrated that there is little appetite for major bank failures. Equity investors lost almost everything in the process, but bond investors walked away with their credit exposure enhanced. The bail-out of Northern Rock sent a similar message. It is equity investors who will take the pain of bank restructuring. Even the best banks will need to recapitalise their balance sheets, diluting equity holders, but strengthening their ability to service debt.

Non-financial companies also offer attractive opportunities, especially outside the US. Default rates have yet to rise significantly and have so far failed to match investors’ fears. Companies enter this downturn with lower leverage and more cash than they entered the last one. According to Barclays Capital average Debt/EBITDA ratios are now 1.9x down from 2.9x in 2001/2002. In addition some traditionally cyclical sectors are performing well thanks to strong demand from emerging markets and renewed infrastructure investment in the developed world.

With signs that the panic is subsiding, we believe that now is the time to build exposure to corporate bonds and high yield at the expense of equities and government bonds.