Politicians in the eurozone have declared their intentions to support structurally weak countries – most recently Spain. However, this process will be slow and hurdles remain; for example the outcome on the European Stability Mechanism (ESM) which will be determined by the German Supreme Court on September 12, 2012. Until further information is available, there is reluctance among international investors to buy debt issued by these countries due to potential risk of restructuring. Additionally investments could become subordinated if public institutions like the ECB or the IMF start to support these countries.
Mario Draghi, the president of the European central bank, recently said: “The ECB is ready to do whatever it takes to preserve the euro”. The firepower of the ECB is extensive and the potential impact of action by the ECB should not be underestimated, especially if combined with an intervention in the primary market by the European Financial Stability Facility (EFSF).
Similar to interventions in the past, the ECB support will only be temporary. Fiscal adjustments and structural reforms need to come from within the countries themselves, and then yields will start to fall. Ireland, for example, has so far successfully achieved this so after asking for support by the EFSF around two years ago. Ten-year yields peaked close to 14 per cent in July 2011 and are now below 6 per cent. The Irish government was also able to tap capital markets with a five and eight year issue in recent weeks.
We have had a cautious view on structurally weak European countries for more than two years and in particular we were cautious on sectors or borrowers with close links to the peripheral markets in Europe (i.e. banks, utilities). This positioning has not altered, as global and regional adjustments will continue for several years to come. In terms of asset allocation, we reduced exposure to riskier asset classes (high yield, emerging markets) before the elections in Greece. As the uncertainty about the outcome is now passed and the volatility in the financial markets has decreased, we have begun to shift back into these investment areas again.
Risk premiums in the credit markets are high by historical standards. Currently, they are around 200 basis points (bps) for global investment grade corporates, 350 bps for emerging market hard currency debt and around 680 bps for global high yield bonds. We expect them to narrow, investors’ hunt for yield will drive them out of the unattractive money market and government bond investments, and into fundamentally sound, higher yielding alternatives.
Although economic growth has been weaker than expected in Q2, we believe that emerging market economies will deliver positive growth this year. Given the favourable growth outlook for this part of the world, the sound fundamentals in these countries and the attractive valuation, hard currency emerging market bonds are one of the most attractive investment areas in the credit space. Viewed from a risk-return profile, investment grade credit also looks compelling. High-quality companies are producing positive free cash flows and have sound balance sheets; default rates and credit migration are supportive, valuations are still attractive and credit as an asset class does not rely on high growth to perform.
Performance of fund and sector over 5yrs
Source: FE Analytics
According to FE data, Fraefel's €117m JB Credit Opportunities fund has returned 58.19 per cent over five years, around the same as the average IMA Global Bonds portfolio. The fund is FSA Offshore Recognised, domiciled in Luxembourg. It has a total expense ratio (TER) of 1.58 per cent.