When fear emerges in markets, many investors claim that everything starts to trade the same. With predictions of a recession in Europe gaining ground as stubborn inflation squeezes both corporate and household incomes, this notion is emerging now, with the debt from certain sectors deemed ‘too risky’ for many.
But it’s during these times that active management comes to the fore, and why it’s vital that fund managers don’t simply ignore whole sectors purely because they’re cyclical.
Overly focusing on the macroeconomic pressures can lead investors to ignore or miss the compelling fundamentals on offer from individual names.
This has been particularly evident within financials, which is a sector that has thrown up some compelling alpha opportunities for those willing to drown out ‘the noise’.
Rising interest rates are a double-edged sword for the likes of banks, with deposits becoming more compelling to savers, but debts becoming more expensive to service for borrowers.
As worries about Europe’s economic performance have grown, many investors have simply jettisoned European banks entirely, focusing predominantly on the potential negative of mortgages; new ones would likely be harder to sell, and existing ones could become more expensive and lead to higher defaults.
This prompted a noticeable exodus from bank debt, in particular, with many investors exiting holdings even if the bank in question was a well-established business with a healthy capital ratio and balance sheet.
For a higher risk, investors often achieved (but not always) a higher reward, but this fire sale of bank debt meant that bonds from higher quality firms have been offering higher yields than some of their lower quality peers.
The fact that the Treasury yield curve is inverted, and two-year yields rose above 10-year yields by the highest margin since the early 1980s should not be ignored.
There can be a temptation when short-term debt carries an attractive yield to ignore these inversions, even though they are an indicator of a potential recession, but we believe it’s prudent to hedge exposure here.
Although we are neutral on rates, we believe that there are opportunities by investing in two-to-three-year debt and hedging this with a 10-year bond. This strategy can lead to an enhanced total return compared to just choosing which end of the curve to target.
Our view is that markets are pricing in a soft-landing for the economy, meaning that if there was a hard landing that spreads would widen.
While such a widening should be more pronounced in lower quality bonds – those below investment grade – there’s a strong potential for investors to secure positive returns from high yield debt even in a hard landing scenario.
Of course, stock selection would be critical here but, because the recent sell-off has been so broad, there are opportunities for those investors willing to unearth them.
We’re neutral to underweight in high yield, but we certainly haven’t dismissed it entirely in the face of the rising recessionary fears.
Exploiting risk dispersion
Essentially, we believe it’s never been more important to assess every issuer’s balance sheet and their ability to pay off or refinance their debt.
Guiding economies through the Covid-19 pandemic has cost governments dearly, with sovereign debt doubling in the past 15 years – a rapid pace considering it took 100 years to double before that.
And with businesses facing higher rates when they come to refinance their borrowing, we believe there’s a rising likelihood that a potential rise in defaults is not being properly priced in.
But thorough due diligence means that opportunities can be found, especially amid geographies or sectors that many might automatically deem ‘too risky’.
The Middle East is an excellent example, with the region often associated with political upheaval, as well as an indelible link to oil.
However, a country such as the United Arab Emirates not only has an enviable balance sheet but is negatively correlated with the oil price because it can produce oil at such low levels and can rely on robust reserves when oil prices are low.
Corporate fundamentals have improved across the Middle East, too, and the region, along with Asia, offer attractive valuations amid the broader emerging market universe at present.
Targeting financials and the Middle East might seem counterintuitive at the precipice of an economic downturn, but assessing which countries have less exposure to recessionary forces and identifying firms that have the least refinancing risk is a sensible strategy with uncertainty looming.
Camila Astaburuaga is co-portfolio manager of the New Capital Wealthy Nations Bond fund. The views expressed above should not be taken as investment advice.