Fixed income markets are demonstrating “real value” compared with equities although investors should not invest indiscriminately, according to Hermes Investment Management’s Andrew Jackson. 
The Hermes head of fixed income (pictured) said credit fundamentals and affordability were broadly positive despite some of the challenges posed by a rate-rising environment.
Jackson said that having been stretched for a long time, valuations were now more attractive while the relative value of bonds against equities appeared favourable.
“Across the corporate world, I see evidence that balance sheets look robust, leverage is not imperilling companies and interest coverage ratios are good – even when likely interest-rate increases are taken into account,” he explained.
He added: “I like this credit environment – so much so that I believe in being almost fully invested, but not exposed indiscriminately across the market.”
Indeed, Jackson said he had not “started seeing silver linings on every cloud”, although there were a number of positive developments for credit markets
The Hermes fixed income head noted that global default rates should remain benign with no significant rise expected over the next two years.
Jackson said balance sheet leverage has risen in the US, encouraged by “unprecedented liquidity, which alongside the aggressive US fiscal policy, is encouraging companies to borrow at low rates to spend high”. Yet, there are few signs that the companies are over-levered.
“Despite what we tend to read, the vast majority of lending still supports credit fundamentals – such as investment, capex [capital expenditure], refinancing – not dividend recapitalisations or share buy-backs,” he explained.
One of the areas of the market favoured by Jackson was higher quality bonds with longer maturities from European or emerging market issuers that were trading at more attractive valuations than expensive high-yield bonds.
“Spreads on both leveraged loans and high yield have widened year-to-date,” he said. “We believe that loans can provide better value due to the potential for higher recovery from greater security.
He added: “In high yield, we will opportunistically pursue certain bonds that have been impacted by rates moves and currently provide positive convexity. However, we will avoid lower-quality CCC-rated bonds which have rallied year-to-date.”
Within this, longer-dated issues are where he said there is an “attractive combination of relative under-ownership, superior roll-down and convexity”.
“Cable and satellite is one of our preferred sectors, as we believe secular changes will impact companies across the quality spectrum,” he added. “In turn, this creates opportunities to invest in issuers with appropriate capital structures and enough levers to weather the storm.”
Elsewhere, ongoing trade tensions between the US and China have filtered through to emerging markets more broadly resulting in a re-rating for some bonds.
The asset class has also been hit by rate-hiking in the US and the strengthening of the dollar, leading to some attractive opportunities.
“Spreads on emerging market credit have widened by approximately 31 per cent, weighed down by a stronger US dollar and geopolitical factors,” he explained. “However, emerging markets continue to offer diversification benefits and this sell-off presents a tactical buying opportunity.”
As such, the firm favours investment-grade emerging market debt over high yield issues and, on a regional level, Jackson said Latin American debt looked particularly attractive following underperformance this year.
He added: “Geopolitics are, however, unpredictable and headline risk is high. Investing in emerging market credit may require long-term thinking and a strong constitution.”
Yet, Jackson said while asset prices suggest that the probability and likely severity of any tail risks are low, investors should not be complacent.
“So far this year, economic data have been cautiously positive, with global growth now back at the levels that prevailed last year,” he said.
“However, the balance of risk is skewed to the downside: global growth has desynchronised, China’s economy is continuing to slow, protectionism is on the rise, and the risk of a global liquidity squeeze is growing.”
The “huge uncertainties” in geopolitics, currently headlined by trade disputes, is a tail risk that many investors are too complacent about, according to Jackson.
He added: “China’s share of international trade now exceeds that of the US, making trade tensions between the two countries inevitable and a geopolitical risk going forward.
“The macro impact of measures announced so far is marginal, but a broad-based retaliation would have vicious consequences.”
Another tail risk is a more disorderly end to the unprecedented support for the financial system, as central banks begin to reverse quantitative easing and raise interest rates from record lows.
“The US Federal Reserve and the European Central Bank have also managed to provide clarity through forward guidance,” he said. “This may be more difficult in the future and markets may, as a result, become more skittish.”
Additionally, global financial conditions have also tightened reflecting higher rates, the stronger US dollar and higher oil prices, according to Jackson.
He noted that a decline in global M1 growth – the most liquid portions of money supply – suggests global monetary tightening and a US dollar shortage are causing a “global liquidity squeeze” with emerging markets most vulnerable.
Jackson concluded: “Given the fact that markets appear highly complacent about the potential for any major downturn and that implied volatility is incredibly low, most investors could consider out-of-the-money options to mitigate the risk of loss in tail events.”