In a risky credit cycle are bonds a safe haven for income investors?

Rising yields have reignited investor interest in bonds but with potential corporate defaults on the horizon, bond managers are selective.

High interest rates may bode well for bond managers but not so for borrowers. Indeed, high rates which in turn drive high debt loads could have a domino effect on the current credit cycle, according to latest analysis from Janus Henderson Investors.

The investment manager’s Credit Risk Monitor assesses where we are in the credit cycle by tracking factors such as cash flows, access to capital and debt servicing levels of a business. These indicators were all in the red for the fourth quarter in a row. In other words, Janus Henderson is seeing the potential for corporate defaults.

The fundamentals of both investment grade and high-yield corporate credit have shown resilience, according to Pimco head of Australia and co-head of portfolio management Rob Mead.

Investment grade credit implies low default risk while high-yield corporate credit has a higher probably of defaulting on its loans. As the name implies, investors also receive greater interest or a coupon rate to compensate them for this additional risk.

“The credit quality of investment grade companies has been strong, with many generating excess cash flow even in a recession,” Mead says, adding that their balance sheets have improved – even as public sector debt has grown.

Similarly overall credit quality has improved even in the high-yield credit market.
“While there are pockets of weakness, fundamentals have remained resilient, especially in defensive and less cyclical sectors. High-yield default rates have remained low,” Mead says.

He acknowledges that tightening financial conditions will eventually have an impact.
“Default rates are expected to increase modestly from current low levels but remain in the low single digits, well below previous recessionary peaks.”

Under such challenged outlook, for these bond managers, it is important to be selective.
As an active investor, with “robust bottom-up credit research “capabilities, Mead believes higher all-in yields levels offer investors both improved opportunities for income generation as well as greater downside cushion.

Mead is finding value in non-cyclical sectors such as utilities and healthcare that can better weather an economic downturn as well as industries benefiting from consumer demand shifting from goods to services and the broader re-opening, such as leisure and travel.

Other sectors include as telecom/cable/towers, which benefit from high barriers to entry and strong demand for broadband and connected devices.

He also sees a value in large “national champion” banks. “In spite of the significant shock to the sector in March, bank fundamentals remain quite strong and valuations for “national champion” US and European banks continue to look attractive when adjusting for fundamentals.”

“Senior securitised credit like senior non-Agency RMBS, which continues to benefit from the steady U.S. housing market and is supported by limited long-term supply and strong borrower fundamentals”, is also in the portfolio.

A peek into Janus’ local fixed income strategy sees exposure to corporate credit but also a large allocation to government bonds.

Morningstar CIO Matt Wacher also likes government bonds particularly in today’s uncertain environment.

“The conflict in the Middle East and the subsequent global reaction is likely to add to investor risk aversion, on top of that, a strong jobs report has caused bond yields to jump to multi-decade highs,” Wacher says.
Given the confluence of these issues, “we assess the ‘safe haven’ status of Government bonds.

“It depends on the risk in question, but we believe Government bonds still play a prominent role in risk management.”

Importantly Pimco’s Mead reminded investors about the attractiveness of bonds compared with term deposits embraced by income-hungry investors at the recent Morningstar Investment Conference for Individual Investors.

“Bonds are really the only true defensive asset. Cash is a temporary defensive asset.
“If economies do slow further and interest rates come back down, you don't get the benefit of that in a term deposit, whereas you do in the bond market, you are getting a very attractive return. It's not just a high nominal return, but you're also earning a real return now.”