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Fidelity’s Spreadbury: Where the value is in fixed income

05 March 2014

FE Alpha Manager Ian Spreadbury says it's too early to buy back into emerging market debt.

By Ian Spreadbury,

Fidelity

1 – Core government bond yields are unlikely to rise

Nominal GDP is a simple proxy for Gilt yields, with Gilt yields tending to be about 0.5 to 0.75 per cent below nominal GDP. With nominal GDP forecasts around 4.6 per cent for 2014 and 2015 (2.4 per cent real GDP + 2.2 per cent inflation) – and even that seems high – there is little scope for significant yield increases.
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With inflation more likely to surprise on the downside than the upside, the possibility of yields falling (as they have recently) remains very real.



2 – Credit fundamentals are mixed, but spreads are attractive

Companies are cashing in on cheap credit by increasing leverage. At the moment, this is not a huge cause for concern as profit margins remain wide and there is little upward pressure on wages.
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Whilst yields have come in significantly across the credit spectrum from the highs of the crisis years, the spreads on offer mean investors are still amply rewarded for taking credit risk – particularly in light of current low default rates.



3 – Growing markets for alternative credit structures

The search for yield is fuelling a growth in the market for bonds with different capital structures – with issuance in hybrid and contingent convertible (CoCo) bonds in particular booming.

Corporate hybrids, excluding those issued from banks and insurers, are securities with both debt and equity-like features.

Hybrids typically rank subordinate to other types of debt, but ahead of equity in the capital structure.
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CoCos are bonds that convert to shares or can even be wiped out if a certain measure of strength (such as minimum capital requirements) are breached. CoCos are invariably issued by financials.

The advantage of these capital structures is that they offer significantly higher yields than conventional bonds issued by companies of similar credit quality, but they are of course riskier in nature and the correlation to equities is higher than is the case for investment grade credit. I selectively invest in these structures.



4 – Developing high yield markets

The high yield market is growing rapidly, with much of the growth coming from Europe and Asia. Cheap credit is keeping many weaker companies afloat and the hunt for yield is fuelling issuance in high risk structures such as Payment-in-Kind bonds (where the coupon is paid in additional debt) and covenant-light bonds.
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This is paving a clear path for the next default cycle once credit conditions start to tighten. The resulting mixed quality of issuance means investors such as ourselves with strong credit research teams can add value through rigorous credit selection.



5 – Opportunities in emerging markets

With investors fixated on short-term risks, sentiment has become outright bearish towards EMD and investors remain mostly underweight the asset class following a position flush-out in 2013.
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While short-term risks remain, the outlook for EMD is starting to show some positive signals. Looking across the asset classes, local currency EM debt offers the highest total return potential, but this is contingent on a pick-up in growth momentum given the higher correlation to EM FX returns.

Now is not yet the time to increase allocation to emerging market debt, but once I do, I am likely to do so through local currency debt.



Conclusion

Overall, I expect the current low growth, low yield environment to continue. The systemic risk in the economy is high, meaning the easy monetary policy will have to continue in order to support the status quo.

The most value in fixed income lies in investment grade credit, where the yields on offer relative to cash and gilts remain attractive.

In the Fidelity Strategic Bond Fund, I am also selectively taking advantage of opportunities in high yield and alternative capital structures whilst always being mindful that the portfolio fulfils its key mandate of maintaining low correlation to equities and adequate downside protection.

Managers

Ian Spreadbury

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