Robeco’s Credit team is growing increasingly uncomfortable. Valuations are at all-time tights. Central bank buying, one of the main supporting factors over the past decade, is about to come to an end. However, Sander Bus and Victor Verberk, co-heads of the Credit team, see plenty of opportunities for active issuer selection.
The US is in the eighth year of economic expansion and markets are enjoying one of the longest uninterrupted bull markets. Inflation remains largely subdued. “Still, we are growing increasingly uncomfortable,” says Sander Bus. “Too much money has been chasing too few assets as central banks have been crowding out investors. Volatility and credit spreads, both measures of risk, have declined to historic lows. This is an indication of risk fatigue: investors no longer dare to take risk scenarios into account as that has been hurting them. The central bank has forced people to follow the flow and close their eyes for risk.”
“It is important to keep the longer perspective into account,” adds Victor Verberk. “We are getting close to the end of central bank buying, the Fed is in a hiking cycle and the credit cycle is maturing. Corporate leverage in the US is high. This makes markets vulnerable.”
“We do not know how much more time there is for this cycle,” Bus continues. “It does not make sense to spend too much time trying to predict a recession, it is enough to conclude that risks are not being priced in at all. This is no longer the time to stick your neck out and take risk. With central banks backtracking, investors are less likely to buy on dips. We are not moving aggressively underweight, but we position our portfolios cautiously in terms of beta. We do see plenty of opportunities for active issuer selection. It will probably pay to focus on conservative credits, which will outperform once spreads start to widen.”
“Many investors feel the need to be fully invested,” says Verberk. “Negative yields on cash are a punishment for being conservative, pushing people into uncomfortably long positions. We advocate not taking too much beta risk in this environment and avoid being addicted to short-term performance.”
Spread products have performed strongly this year. Most credit categories are close to the all-time tights on a risk-adjusted basis. “People often justify tight valuations saying that they do not see a catalyst for things to change,” says Bus. “Well, let’s remember that a catalyst for change is mostly only seen with hindsight. The forest is dry, you do not need to know which match in the matchbox will set it on fire. It is enough to conclude that markets are not discounting any negative surprise and that the cycle is in its mature phase. Reason enough to be cautious.”
“Corporate hybrids and financials still offer value in investment grade. For high yield and emerging markets, we stay as high quality as possible without compromising too much on the beta.”
Verberk sees technicals worsening. “They will no longer provide support with the end of central bank balance sheet expansion nearing. As for supply & demand, Asian investors have been the largest contributors of inflow into the US credit market. This is now slowing down and with the Fed likely to hike rates further, the flow will probably slow further if not reverse. Higher US short-term rates are increasing hedging costs. In addition, a steeper yield curve in Europe and Asia than in the US means that investors can now pick up more attractive yields in non-US assets.”
High yield has been facing shrinking supply. The main reason, says Bus, is competition from the loan market. “Many companies refinance their public high yield bonds with private loans. Discipline in the loan market has disappeared and companies have access to almost unlimited funding without having to give covenant protection or early redemption fees.”
Bus and Verberk run almost all portfolios with a beta close to one. “For high yield and emerging markets, this means that it might end up just under one, since we want to avoid the cyclical companies,” Bus explains. “For investment grade, it is easier to reach a neutral beta as we can still find attractive yield in financials.” “For a long time, we preferred European to US credit. For high yield this is still the case, but in investment grade valuations have tightened due to ECB buying and are vulnerable to a reduction in purchases. Here we have a more neutral regional allocation. In European portfolios, we skew the portfolio to bonds that are non-eligible for ECB buying.”
“We prefer companies in more stable sectors that are less exposed to an eventual turn of the cycle,” Verberk concludes. “We are in general underweight commodities and like banks. In our issuer research, we stress-test the financial models for the companies we invest in for higher interest rates and recession scenarios.“
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