Credit valuations attractive, fundamentals healthy
If we focus in on credit valuations we find levels are now more appealing, with yields now at attractive outright levels, and even offering better income prospects than equities. The difference between the Euro Stoxx 600 gross dividend yield and euro investment grade (IG) yield is the narrowest in nearly a decade, at just over 1.0% at the time of writing. Corporate hybrid bonds (such as perpetual bonds which have no fixed maturity date) are yielding the same as equities.
For euro high yield (which is lower grade credit), a yield premium of 2% is the highest since early-2016, excluding March 2020. In the US, an IG credit yield of 3.2% compares more favourably to the S&P 500 dividend yield of 1.9%.
Credit can also act as a diversifier should growth falter more than expected. Income affords a cushion, while higher grade corporate bonds are less sensitive to growth than stocks. These factors should make credit attractive to a wider, non-specialist investor base, potentially spurring institutional investors or multi-asset funds to increase allocations.
There are still signs of decent activity in the underlying economies of Europe and particularly the US and China has begun monetary easing. This is helpful to corporate fundamentals, supporting earnings which are at record levels. Balance sheets are decidedly healthy too, with companies having refinanced at low levels of interest last year. For euro IG, interest coverage (EBITDA to interest expenses) is over 10 times. Market levels are implying a higher rate of defaults than is likely to materialise based on fundamentals.
At the same time, there is a growing need to be selective. Companies face rising input cost pressures, which may potentially worsen should energy prices rise further, and we are starting to see this impact revenues.
Which sectors are well placed?
We are think sectors with some in-built defensive characteristics, such as inflation protection and strong asset-backing are well placed.
In real estate for instance, many companies have rents linked to inflation over the medium-term and we see logistics and residential companies benefitting from still strong demand. Covenants in bond documents limits leverage in the sector and companies benefit from well diversified property portfolios. Currently, some property company bonds have yields higher than on the underlying property assets. This situation should correct and offers value to bond investors.
A similar example is infrastructure, namely operators of assets such as toll roads and telecom towers which in many cases have revenues linked to consumer price inflation.
Most of the assets are in operation and maintenance capex is relatively low, so cash flows are predictable. A potential recovery in tourism in parts of Europe this summer, with lockdowns having eased, and the rollout of 5G means provide additional revenues for these sectors. These bonds have been under pressure.
The energy sector is seeing a large revenue and earnings boost from higher oil, gas and power prices. We see a good long-term case for integrated energy companies with plans for transitioning to a low carbon and net zero future. Despite record earnings and low leverage, energy sector bonds have experienced sharp price falls, in a number of cases unjustifiably given fundamentals.
In Asia, market dislocation from geopolitical tension would offer attractive opportunities, particularly in the Indian renewable energy sector, where ample demand will continue to support fundamentals.
Credit can stabilise
Alongside the human tragedy of the current situation, this is a moment of great uncertainty on account of numerous, rapidly changing factors.
Given still overall favourable growth and strong company fundamentals we think there is scope for credit to stabilise and start to perform better in time. We retain our conviction in strong sectors and companies, with the characteristics to weather challenging circumstances, looking for opportunities where we find valuations disconnected from fundamentals.
