It was Albert Einstein who said the only source of knowledge is experience. If experience is the best teacher, then 2015 leaves fixed income investors a legacy of five lessons:
- Understand and accept where we are in the credit cycle. In the US, creditor‑unfriendly activities such as mergers and acquisitions, share buybacks and special dividends — typically funded through debt offerings — paint a picture of late‑cycle behaviour in the industrial high yield sector.
- Avoid late‑cycle traps. People invariably become bullish in a late cycle, seeking value where there is none. Many deals have come to the market over the current cycle, which we regarded as value traps. Among them were small business lending, peer-to-peer lending, illiquid trades, structured products, Chinese property trades or Australian iron ore trades – all of which are typical of “animal spirits” so prevalent in late cycles. It takes patience and courage to hold back and say no to the investment.
- Continued re-regulation of banks has left the financial sector in a very different place. With more capital injected, continued deleveraging, rights issues and new chief executives at the helm of a number of banks, the financial sector presents an ongoing positive bond story, albeit at the expense of equity holders.
- In a world of sub-par economic growth, it does not pay to be short duration. Old economic textbooks have been particularly unhelpful in the current economic climate and should have been discarded after the global financial crisis. Over the last two years, investors have been unable to profit from duration strategies.
- Be conscious of investor positioning. Quantitative easing policies around the globe have pushed investors en masse into similar trades, be it a view on the US dollar or the German bund market earlier in 2015. These herd-like positions have a habit of being “washed out” periodically, creating spikes in volatility.
Mindful of the above themes, we remained patient throughout the year, running higher cash positions that can be used opportunistically. Hence we were able to react on the occasions when volatility spiked and attractively valued bonds were revealed. At the same time, we declined many deals throughout the year. Among the reasons were too much leverage, not enough yield (compensation for risk) or simply because of the poor quality of the business.
We believe there is more opportunity in the forthcoming 12 months and are, on the whole, more positive for 2016. This is in part due to the higher bond yields on offer compared with last year. With a lot more negative news already priced in, there should be better value emerging and we expect to see more interesting credits.
Two major investment themes will dominate the bond markets this year. The most important continues to be the credit cycle. The industrial cycle is in quite a late stage, particularly in the US, but in Europe it remains sanguine. European corporates remain more conservative and less levered than their US counterparts and selected industrial high-yield names are attractive.
Europe appears to offer some good opportunities and should be supported by the accommodative monetary policy being pursued by the European Central Bank, which should hold interest rates there low for some time.
The second big theme will be the ongoing re-regulation of the banking industry. It is said banks tend to get the regulation they can afford. We have seen this with banks in the UK, the US and Switzerland. The more financially healthy they became, with more cash on their balance sheets, the more the regulators treated this as the baseline from which to apply more regulation, causing balance sheets to become even stronger. With more regulation expected globally, the financial sector can only get better again. This is an interesting theme, which is independent of the credit and the industrial cycles referred to earlier.
We remain true to our long-held strategy of sensible lending to large, non-cyclical businesses with reasons to exist. These entities typically have relatively reliable earnings and a moderate amount of debt on their balance sheets, which gives them the ability to pay a reasonable coupon.
John Pattullo is co-head of retail fixed income at Henderson Global Investors