Can the strong run in corporate credit continue?
The iBOXX Sterling Corporate Bond Index has returned 24% over the last three years, grinding higher despite many commentators stating that the beginning of monetary tightening will mark the end of fixed income’s bull run. This view has yet to come to pass. Of course, the United States has already embarked on a rate rising cycle, whilst we have also seen government bond yields rise in the UK and the Eurozone more recently. However, these have largely been the result of central bank sentiment swings and have since reversed on more dovish comments.
At Canada Life Investments, we do expect government bond yields to rise modestly over the rest of 2017, but that there will be some underlying volatility beneath the headline numbers. We expect this volatility to present fixed income investors with attractive opportunities, particularly within corporate credit. Despite the ongoing Brexit uncertainties, global economic growth remains robust and we forecast a relatively benign operating environment for companies in the UK and the Eurozone. But where are we finding attractive opportunities?
A look back to the global financial crisis
Many believe that Brexit poses a significant impact to the UK economy at large and to the financials sector in particular, given that it tends to be more geared to economic activity. Ten years ago, when the global financial crisis hit, the sector was hit hard as spreads widened significantly. However, the main problems were in the banking sector, but insurance bonds were dragged wider by association. Over the last ten years, banks have repaired their balance sheets and returned to profitability, leading to financials being the best performing part of the credit market. This has continued in 2017, suggesting that the credit market is not overly worried about the Brexit impact on financials.
Insurance versus banks
We believe banks as a sector are relatively fairly valued at present. However, there is one part of the financials space that has been somewhat left behind in this rally – insurance. It is a more niche part of the market, with complicated financial reporting and is thus often avoided by many investors. However, we believe we have the expertise given the nature of our wider business and the strength of our Credit Analysis Team to identify attractive opportunities. The CF Canlife Corporate Bond Fund has been overweight insurance over the last 3 years, but the inherent value of the sector has not begun to be realised by the market until 2017. Despite this, it still remains the highest yielding part of the market and we believe further upside remains.
Source: Markit, semi-annual yield, as at 17/08/17.
We believe the attractiveness of the insurance sector can also be highlighted in its spread profile. The iBOXX Sterling Financials Index is currently trading effectively in-line with the wider corporate space, whereas insurance is at significantly wider levels. Now, financials have a low spread overall as the index contains a large proportion of senior bank debt, which tends to trade very tightly. In contrast, insurance bonds tend to be largely subordinated. This could therefore give the illusion that the insurance sector is cheap. However, comparing purely subordinated bank debt with subordinated insurance debt highlights that banks are still trading at a significant premium to insurance companies on a relative basis. Therefore, despite our insurance allocation proving to be a bit of a drag on performance in 2016, we believe its more recent outperformance can continue, as spreads compress further on both an absolute and relative basis.
Source: Markit, semi-annual benchmark spread, as at 17/08/17.
Source: Markit, relative spread, as at 17/08/17.
During the financial crisis insurance sold off alongside the wider financials sector, without any change to its fundamentals. Everyone remembers the implosion of AIG, but its problems came from non-insurance activities. At Canada Life Investments, we undertake all of our own credit research, assigning an internal rating to each bond we invest in. As a result, our credit research and selection process has favoured insurance as we believe, for example, we can invest in insurance bonds that are the same credit quality as bank bonds, but receive more in return. Furthermore, the modestly higher yield outlook that we forecast should be as supportive of insurance as it is of banks.
What about the macro?
The impact that Brexit will have on asset prices remains unknown. At present, it appears that neither the credit nor the equity market are concerned, with regard to financials. We take the view that, although it may increase costs, Brexit will not equal bankruptcy for large, blue-chip banks and insurers. Therefore, in this regard, insurance bonds are likely to be more defensive than the associated equity from a total return perspective and still perform well versus other financial bonds and the broader corporate bond market. In 2017 so far, the CF Canlife Corporate Bond Fund has returned 4.08% versus the iBOXX Sterling Corporate Index gain of 3.53%. The CF Canlife Short Duration Corporate Bond Fund has returned 1.95%, outperforming the iBOXX Sterling Non-Gilts 1-5 Years Index return of 1.40%.*
*Source: Morningstar, as at 31/07/17. C Acc GBP share class performance, bid-to-bid with net income reinvested. Past performance is not a guide to future performance.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. The contents of this article are not intended as investment advice.
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