A few months ago I remarked to my co-manager Jenna Barnard how boring corporate bond markets were. Be wary of what you wish for, I hear you cry. We were cognisant that US credit markets were displaying late‑cycle behaviour. Merger and acquisition activity was high and it was not an environment in which credit investors were being well rewarded.
We had a growing niggle, however, that global bond yields may keep falling against mainstream consensual thinking, given the appalling global growth picture post-financial crisis. Hands up we, like many, did not call the Brexit result but three weeks later we keep coming back to the same conclusion: for the best risk‑adjusted returns in credit markets buy quality industrial, large‑cap, non‑cyclical investment grade bonds. This rather simple strategy will not let you down. Let me explain.
Led astray by the science of economics
In 2010 we went short duration in our funds, partly due to overconfidence after a rather successful credit crisis but also due to our orthodox university training in the dismal science of economics. Sterling fell very heavily in 2008 and we did import a lot of temporary inflation. The Bank of England saw through this and fortunately did not raise interest rates, as neither companies nor individuals had the power to pass these imported costs on in higher prices or wages. I would suggest a not dissimilar outcome will happen again.
Behavioural responses to traumatic events matter
It was after reading economist Richard Koo’s book in 2011 that we completed a volte face in our duration thinking. Koo predicted Europe would “turn Japanese” nearly six years ago and, frankly, he has nailed it. He coined the phrase “balance sheet recession”, whereby individuals or companies experiencing negative equity post a financial crisis only want to pay off debt and deleverage. Thus, lowering interest rates is a completely ineffective policy tool. Koo is highly critical of the economics profession, as it completely ignores behavioural responses to traumatic events.
Many commentators have likened Brexit to bereavement — something I felt myself. Our macro outlook remains realistic but fairly dismal regarding growth and inflation. Aside from Brexit, we have serious concerns about falling Japanese bond yields, the strength of the yen and the almost inevitable threat of a Chinese devaluation, which will bring yet another wave of deflation. We have long been big fans of Larry Summers’ “secular stagnation” theme. Brexit has exaggerated this view and, unlike the English football team, has brought it home.
Interestingly, in his recent speech, Bank of England governor Mark Carney spoke about “economic post‑traumatic stress disorder”. In his words “EU exit would bring about major regime change”. He seems to agree major events result in behavioural changes.
We expect interest rates to fall by 0.5 per cent very soon, likely followed by a corporate bond buying programme and cheap funding schemes for the banks. We also expect a major fiscal response to the UK’s predicament and only wish our European counterparts would follow a similar route. Fiscal expansion has been tried in Japan of course but with limited success, as the necessary structural reforms were not undertaken alongside economic reforms.
Throughout last year, we suggested investors should not be tempted to ski off‑piste in the afternoon sun, getting into overly levered structured products, peer-to-peer lending and so on. In addition, we materially reduced our high yield book in favour of long‑dated US investment grade credit.
We continue to favour the refreshingly simple, reasonable-to-high credit quality names and have focused entirely on large‑cap, non-cyclical, consumer facing “reason to exist” credits such as Kraft Heinz, Boots Walgreen and Verizon. Why? Because in 30 years’ time we believe these companies will still be paying reliable, dependable coupons to their bondholders. If anything, we may pursue this global titans strategy even further.
Bond returns will be all about “income” in the future. We want to lock this in for as long as possible. We expect global bond yields in the high yielding countries of the UK and the US to fall further, and believe their yield curves will flatten even more as international investors seek out yield. We expect investment grade bonds to party on as the global grab for yield continues.
So, to summarise, at the margin we continue to prefer duration risk over default risk. It is as simple as that.
John Pattullo is co-head of strategic fixed income at Henderson Global Investors