Capital Ideas^TM

Introduction

Although global investment grade corporate bonds posted negative total returns in 2021, in large part due to rising government bond yields, excess returns were positive¹. 2021 also proved to be a year characterised by low spread volatility ¹supported by strong global growth and accommodative monetary and fiscal policies, although this was peppered by modest bouts of volatility linked to inflation fears and the pandemic.

As we enter 2022, investor concern has shifted towards a litany of macroeconomic concerns that could hurt credit quality and market performance. Following the initial burst of activity experienced in 2021 as economies came out of lockdowns, the pace of global growth is now slowing. Inflation has been at the forefront of investor concerns leading to worries about how much monetary policy tightening is in store from major central banks. COVID-19 also remains a risk, not least with the emergence of the new Omicron variant, which has already led to a resurgence of restrictions in many countries. There are, however, still reasons to be optimistic. While valuations are stretched leaving little room for error, improving issuer credit fundamentals and investor demand for yield may help to keep the market supported. However, given an increasingly asymmetric risk/return profile now is the time to be selective.

Valuations are stretched, but improving fundamentals and a still positive technical backdrop should help.

Although spreads widened towards the end of last year, most significantly in November, they recovered part of that widening in December. More importantly, spreads remain at the tight end of their historical range leaving little room for error. Even a modest widening in spreads could be enough to wipe out a year’s worth of total returns. In the current environment, with limited scope for further spread compression, an overall cautious credit stance limiting downside risks could be considered prudent.

This year could see a gradual rebuilding of market risk premium that would likely realign spreads with the reality of a maturing cycle. Gradual withdrawal of monetary stimulus and a lower risk appetite could turn incrementally less supportive as the cycle continues to mature. Interest rate volatility and further COVID-19 related worries could also add to credit market volatility and drive spreads wider, bringing potential opportunities to add on weakness as fundamentals remain solid.

Credit metrics are improving alongside lower debt and strong EBITDA²

Corporate fundamentals have generally improved following the damage inflicted by the pandemic. As businesses worked to repair their balance sheets and economies re-opened, many companies saw their earnings and profitability improve.

Over the third quarter most credit metrics showed significant signs of improvement, though there are some initial signs that inflation could be beginning to impact margins. Leverage ratios declined while at the same time interest coverage ratios increased, a trend which looks set to continue. Strong EBITDA growth alongside reductions in debt growth have driven this deleveraging. While debt growth may reverse course on the back of strong economic activity, EBITDA trends are likely to remain strong, which could lead to a continued reduction in leverage.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.