In a market dominated by technicals, Michel Canoy, head of retail credit at Legal & General Investment Management, examines the balancing act in bonds.
Corporate bond markets have delivered returns ahead of expectations this year, which raises the question of whether this bull run will continue. There are certainly risks that need to be managed but credit remains an attractive asset class.
We are at the end of a cycle and I expect bottom-up factors will now be more important than top-down. In this environment, it is not easy to make money (in any asset class) but I expect there will be greater performance differentiation between individual names going forward.
This plays into the hands of those who have expertise and resources devoted to fundamental research – which is how most value will be added this year. For funds that have the flexibility, adopting a barbell approach of blending investment grade with the best high yield opportunities is a smart approach.
Credit where it’s due
Despite being under the pressure of struggling economies, bond markets are supported by strong technical drivers that I believe will persist for some time. More and more institutions are struggling to match their liabilities, feeding demand for fixed income securities.
After a period of being underweight peripheral Europe, they have been watching the markets rally – dramatically so in the case of Italy. They are now adopting a ‘wait and see’ position, moving from underweight to neutral in order to not fall too far behind the benchmark.
In addition, there is a fundamental imbalance between supply and demand in the market. Liquidity in the secondary market is especially poor, although this is being disguised by the flow of quantitative easing capital. When combined with a temporary deflation effect, this is exerting a powerful downward force on yields.
Investors have been forced to move into riskier assets in search of yield but, as spreads have become increasingly compressed, the money keeps pouring in at the top end of the market.
The primary market is seeing a healthy amount of new issuers because companies are coming to capital markets for funding as an alternative to banks. This is a welcome chance for fund managers to source opportunities, since companies with the best profiles are difficult to buy in the secondary market (those who already hold them have no reason to sell).
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