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Credit where it&#39s due

Credit spreads have held up well amid the turmoil in equities. We see this as growing evidence of a decoupling of credit from equities – with credit outperforming.

Many of the recent “winners” have been lower-quality, more distressed names such as telecom operators. Arguably, therefore, the decoupling has as much to do with fundamentals, namely, the process of corporate balance sheet repair, as it does to technicals.

The environment of modest growth provides the perfect foundation for credit – enough momentum to prevent a fall back into recession but not so much as to divert management attention away from balance-sheet repair and back towards re-leveraging. It would be premature to get too carried away with such a nascent trend but if other company managements follow the responsible lead now being adopted by telecom operators, the credit markets might be forgiven for getting excited.

Typically, over the longer term, returns from corporate bonds rank somewhere between equities and government bonds. Government bonds have been well supported over the last two years, due largely to weak economic data and heightened geopolitical tensions. But with real yields now testing historic lows at sub-2 per cent, further significant strength in government bonds is unlikely.

As for the outlook for equities, forecasts are for anything from a fourth successive year of negative returns to a strong market rally. Somewhere in between is probably most likely. We would not rule out a modest improvement in equities from current levels.

This brings us back to credit. We may have reached the stage in the business cycle where corporate bonds become the asset class of choice.

Certainly the supply and demand technicals are stacking up nicely. In the UK, there is a huge pipeline of demand from institutions and individual investors who are recognising the need to hold a greater proportion of their assets in bonds. The buy case for corporate bonds is beginning to look like a no-brainer.

There are risks. Many corporate bonds are overpriced. This includes those at the upper end of the credit curve that have benefited from a momentous flight to safety over the last 12 months and those lower down trading at distressed levels because they deserve to be.

Investors should identify companies that are demonstrating a willingness to deliver by cutting costs, disposing of assets or restructuring. These will be best equipped to improve margins and their credit profiles.

There are many such examples of these firms among A and BBB-rated companies but credit research and careful stock selection has rarely been more important in a market which is offering potential but which still contains many pitfalls.


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