This week’s investment soundbite from FundCalibre is with George Curtis, portfolio manager and member of the Multi-Sector bond team at TwentyFour Asset Management.
What is your outlook for the global economy today? And how might that impact bonds in the next 12 to 18 months?
“We see three main scenarios. Our probability of a hard landing has reduced to somewhere around 20%, and we see equal probability of a soft landing or a softish landing – a softish landing being one where we do see a recession, but where we think the unemployment rate and default rates will stay lower than they have been in previous recessionary cycles. In a large part this is because we think corporate balance sheets and consumer balance sheets are in a very strong place.
“Where does that leave us for fixed income? Well, fixed income’s a very interesting place at the moment. Starting yields at the beginning of this year were the highest in over a decade across both high yield and investment grade, and indeed, government bonds. So, while we expect volatility to remain elevated in the coming 18 months, we think the outlook for fixed income is positive given those elevated all-in yields.”
Tell us about the opportunities in high yield
“99% of defaults happen in the high yield sector. So, in order to be invested in this sector, you have to have a good idea on your default outlook. You also have to do rigorous bottom-up analysis. Interestingly, given all of the tensions we’ve had in the macro side of things, the default rate outlook has remained very benign. And that’s for one of the reasons I mentioned earlier: corporate balance sheets are in a very strong place. Leverage is at the bottom of the decade low. We have interest coverage – which is a metric measuring earnings over interest – at all-time highs. And we have cash as a percentage of debt on balance sheets, at record highs.
“Having said that, we don’t think this is the time to be reaching for yields. So, within our portfolios, we have been reducing our exposure to high yields, particularly given the yields that we are seeing in higher quality areas of the market now. But also, we want to reduce our exposure to those names that are most sensitive to recessions, and the names that we have been invested in, we want them to have strong pricing power, so our overall allocation to high yield has reduced. And within the high yield bucket, we have moved up in quality.”
What about different regions for high yield?
“The way we think about regions is we look at things on a fundamental basis. We look at things on a valuation basis. Fundamentally, you’d probably want to be in the US, right? Because you’ve got a labour market that’s at record lows, you’ve got inflation that’s coming down faster than it is in Europe, faster than it is in the UK.
“But dollar high yield is more expensive than euro high yield or sterling high yield. So, valuations in Europe are cheaper. The dollar high yield index is trading at a dollar yield of 8.5%. If we take the euro yield on the euro high yield index and swap it into dollars, so we can measure apples to apples, the yield on the euro high yield index is 1.3% higher than it is in the US. And it’s worth saying that the US high yield index is lower quality. The average credit rating, which is a measure of risk, is B+ versus BB- for European high yield. So, European high yield is more highly rated. So, we view these things on both the fundamental and a valuation perspective. We have a relatively equal weight within the portfolios of US high yield and European high yield at the moment. But both, as I mentioned, have reduced over the last 12 months.”
What about UK high yield?
“The sterling high yield market is much smaller than both the euro high yield index and the dollar high yield index. The dollar high yield index is 2 trillion dollars; European high yield index is 500 billion euro; sterling high yield index is 60-70 billion pounds. So, it’s significantly smaller. It’s a slightly more illiquid market, and generally trades at higher spreads than both Europe and the US.
“Interestingly, the spread between sterling high yield and euro high yield is the highest that it’s ever been. It was at its 99th percentile at the back end of last month. So, we certainly think there are interesting opportunities in the sterling high yield space with all in yields over 9%.”
Tell us about investment grade corporate bonds
“Investment grade is more attractive than it’s been in a long time. Given the move we’ve seen in government bond curves, given the spread widening we’ve seen in credit, yields are significantly above their longer-term average. So, euro IG [Investment Grade] for example, is yielding you approximately 4% in euros. If I swap that back to sterling – and we are not FX experts, we swap everything back to the base currency of the fund – that’s a sterling yield of 5.5% for an index that is rated A-. So, absolutely no default risk. These are the largest companies in the world. The 10-year average for that index is 1.2%. So, we are over three times higher than the 10-year average. The 20-year average is 2.6% – and that obviously includes the financial crisis where yields went to over 7% in euro IG. So, we view euro IG as attractive.
“Our preference within that space is to invest in financials. Banks have, since the financial crisis, had a decade of capital generation, building capital at the behest of the regulator. But it has meant that they have rock solid balance sheets, which ultimately protect us as bond holders. There is a lot of protection for us as bond holders, even in the more subordinated part of the capital structure within a bank’s balance sheet. Take a Barclays [bond, for example], one of the biggest banks in the UK. They issued an investment grade-rated, subordinated financials bond yesterday at a yield of 9.25%. This, to us, seems like very good risk to hold throughout the cycle, whatever your view on the macro is. So, this is what we’ve been doing in investment grade.
And government bonds?
“Government bonds now offer you yield, they offer you protection, and they offer you flexibility. We have a preference for [US] treasury curves because we have better clarity on what we think the Federal Reserve is going to do. And inflation is coming down faster than it is in Europe, but also it’s a much more liquid market. And we want that flexibility in our government bond bucket. We want flexibility to go from short-dated government bonds to long-dated government bonds, which we’ve been doing over the last 12 months. At the moment, we think there are very few scenarios where you lose money in a 10-year US treasury at 4%, over a medium to long-term view.
The TwentyFour Dynamic Bond fund has been reducing its exposure to emerging markets. So maybe tell us a little bit more about that?
“Coming into 2023, there were probably good reasons to be optimistic about emerging markets. The Fed had started to slow their pace of rates, the dollar started to weaken versus a very strong 2022, and these things are usually positive for emerging markets. That, coupled with very high yields. But I would say that, on a relative value basis, developed market yields are also significantly higher than they were 12 months ago. If we can get a triple B, an investment grade bond of a Barclays, a big UK bank, at 9% or 10%, then you don’t need to reach for yield. You don’t need to go into a small Latin American telecoms producer or whatever the company is, because there is a significant yield on offer, and developed markets usually lead the recovery. So, that’s the first point.
“I would say the second point is the ESG landscape of emerging markets has become much more difficult to navigate, with the likes of Russia and Putin invading Ukraine, with the likes of China’s property market – which is almost 25% of their GDP – a large part of whose bonds had to default. So, you have to have a very thorough view on the political environment, and it just makes the analysis of governance within your ESG calculation, much more difficult.
“So, we have significantly reduced our exposure to emerging markets over the last 18 months. I wouldn’t see it increasing much in the short-term from here.”
Listen to the full interview below.
[Main image: pawel-czerwinski-eybM9n4yrpE-unsplash]
