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Fixed income opportunities: finding value in a low yield environment

There is an optimistic feeling to markets, investors are buoyed by positive vaccine news, Joe Biden’s fiscal plans and Mario Draghi’s entrance into frontline politics. Economic growth is expected to recover strongly and inflation is set to jump as household savings are put to work. It does feel as if there is some light at the end of the tunnel but we are also cognisant that there is a lot more of the story to unfold.

Despite low yields and tight spreads, opportunities to generate returns in fixed income do exist. There’s plenty investors can do to take advantage of a recovery. Moving out of areas like financials that now appear to be fully valued in some cases into some of the cyclical non-financial sectors makes sense at this juncture.

Although the recovery has been noted in most areas of all markets, some have been left behind, relatively at least. European high yield for instance is a very cyclical market and has not yet fully recovered, perhaps offering stock pickers some great opportunities, and the same can be said for lower rated areas of the investment grade markets.

Many sectors suffered as a result of the various lockdowns and the restrictions put in place due to the coronavirus pandemic. However, some businesses have suffered disproportionately such as autos, non-essential retail, transport and hotels. Airlines and airports have seen their revenues collapse and will only recover fully when life gets back to the ‘new normal’. Admittedly, a lack of recovery in 2021 would see greater challenges but an end to lockdowns later in the year would deliver a massive boost to short haul markets in particular. Similarly, hotels and non-food retail, which would benefit from the spending spree that would likely follow as a ‘return to normal’ is exploited.

We have been gradually adding exposure where the valuations look compelling. In the retail sector, Macy’s in the US and UK-based Next have both proved resilient to the crisis as has Hammerson, the British property development and investment company, which has significant exposure to the retail sector. In the hotels sector, Whitbread (which owns Premier Inn) recently brought a new corporate bond issue to the market which saw huge demand. Despite the considerable downturn due to Covid-19, where sales declined 55% in the third quarter of 2020 compared to 2019, the company raised £1 billion via a rights issue and implemented a major cost cutting plan to limit the loss of revenue. An additional attraction of increasing our exposure to Whitbread is that it is mainly focused on the domestic sector and likely to benefit the fastest in case of a recovery driven by an easing of lockdown.

The UK’s main airports also suffered similar collapses in revenues with traffic down between 40-60%. Heathrow, Gatwick and Manchester Airport Group all have investment grade bond issuance outstanding and spreads were quick to price in material risks during the eye of the storm. Providing we see some form of recovery from the pandemic in the months ahead, it likely this will benefit all three airports. Gatwick, in particular, which is most exposed to leisure traffic. Encouragingly, in the meantime, all have sufficient liquidity to cope with the current environment.

Despite many reasons to be optimistic, it is crucial to remember that the path out of the pandemic is unlikely to be an easy one. When looking for recovery stories or ideas of where to invest it is important that the companies and sectors are resilient and able to withstand the more feared outcome of a lengthier pandemic. Additionally, for stock pickers, an understanding of valuations is key but also the ability to factor in analysis of the downside risks is just as important to capturing the upside from here on.

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