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The bombed-out areas of the bond market that now offer value

15 February 2016

Fraser Lundie, co-head of credit at Hermes, tells FE Trustnet why investors hiding behind European holdings at the moment should be doing the opposite, and should turn to commodities, emerging markets and US high yield for safer long-term plays instead.

By Lauren Mason,

Reporter, FE Trustnet

Investors should feel comfortable upping their exposure to some of the most bombed out areas of the bond market such as US high yield, gold and emerging markets, according to Hermes’ Fraser Lundie, who says investors are wrong to run to European bonds for safety at the moment.

The co-head of credit, who runs global high yieldmulti-strategy credit and absolute return credit portfolios for the firm, says that there are potential tailwinds on the horizon for the US sparked by the slowdown in dollar strength, while European credit has higher exposure to banks and financials and could therefore find itself in hot water.

Performance of indices in 2016

 

Source: FE Analytics

US high yield bonds have fallen out of favour significantly over recent months due to a combination of impending rate rises from the Fed, liquidity concerns and fears surrounding defaults within the US energy sector.

European high yield, on the other hand, has proven to be more popular among investors due to a strong post-financial crisis recovery, Draghi’s decision to keep interest rates low and in previous years, an attractive liquidity premium.

However, Lundie (pictured) believes that this could be set to reverse and that bond investors who think they are protecting themselves by investing in Europe could in fact be doing the opposite.

“We’ve now got to the point where the US has never traded as wide compared to Europe as it does today - broadly speaking we’re at 9 per cent to 5.5 per cent,” he said.

There are some reasons for this – energy, a credit quality mismatch, a little bit of a duration mismatch, and what’s been happening over the last couple of years is that oil has gone from $130 to $26. That’s obviously hurt the US because it’s very exposed to oil and gas-based industries.”

The manager points out that, because interest rates in developed markets are now so low, the main area of concern for investors is gradually shifting from commodities to banks, which are being hit by non-performing loans, energy exposure and flat interest rate curves.

Because Europe is more heavily exposed to banking and the financial sector, he says that Europe is already starting to feel reasonable amounts of pain while, in the US, the drop-off in increasing dollar strength is breathing some relief into a number of commodity markets.

“Investor sentiment is completely the wrong way round at this point – everyone is extremely negative towards anything to do with commodities – so emerging markets and US high yield – and everyone has been positioned this year in a way that they’re hiding behind European banks and European high yield, and that might well be pushing things to a turning point,” Lundie explained.


“When the market is as illiquid as it is right now positioning and sentiment will mean more than it should do. If everyone’s already in a trade and that trade starts to look quite worrying then it’s very difficult to get out of it. Equally, if no one is involved in a trade like commodity-focused high yield and it starts to look like it’s bottoming out then it can very squeeze up.”

The manager believes that the biggest area of value in the market right now is the lower end of investment grade and high yield bonds in the US, because he says that the market has been unfairly sold off in correlation with oil.

Another area of the market he feels has been unfairly linked to oil is gold, and as such he has bought into the world’s largest gold mining company Barrick Gold due to attractive valuations.

Performance of indices over 1yr

 

Source: FE Analytics

In terms of commodities generally, Lundie is mostly positive in terms of the steps that companies are taking to reduce debt levels by slashing dividends and putting shareholders to one side for the time being. An example of this is Rio Tinto, which reduced its dividend at the tail end of last week due to a worsening global economic outlook and commodity prices falling to multi-year lows.

Meanwhile, while many investors are also bearish on emerging market credit at the moment and would view it as a deep value play, the manager says that it has done surprisingly well and valuations have actually played out to a certain extent in the sector.

Despite this, he has still found particularly contrarian areas of the market that he deems to be undervalued and attractive.  

“We have a couple of holdings in Russia. A year ago you wouldn’t have necessarily been saying that Russian credit would be a safe haven but it has been for us, it’s been our best performer,” he said.

“We still like the Brazilian food space and have bought into Marfrig for example. It’s the biggest beef exporter in the world and it’s the main supplier of beef to McDonalds. It’s a proper company but it’s based in Brazil, so automatically it’s been tarred with a Brazil brush.”

“It benefits to some extent from local currency weakness in Brazil because it sells beef in dollars to the US and importantly, it’s been moving in a very defensive manner.”


Three months ago, the company sold its European food unit Moy Park as part of its plan to reduce its debt by $1.2bn by the end of the 2016.  Lundie pointed out that, in any normal market, this money would have been paid to shareholders rather than contributed towards debt reduction, and as such he says it is a particularly attractive holding for fixed income investors at the moment.

“People are unfairly categorising everything as being in the firing line of emerging market stress and actually there are a lot of companies in that space that are doing well,” he said.

“I’m not saying that the shift in high yield and commodity-related markets is definitely going to happen, I’m just saying we’re potentially at a point right now where the market is having to rethink whether it’s such a good idea to be so heavily skewed in one direction.”

Lundie has outperformed his peer group composite over one, three and five years as well as over the last three and six months.

His performance has been particularly strong over the last three years, where he has outperformed his composite by 4.5 percentage points with a total return of 11.23 per cent.

Performance of Lundie vs composite over 3yrs

 

Source: FE Analytics

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