Nicola Mai

So, Charlie, obviously a key question that people are asking is what is the macro-outlook for the European economy over the next 6 to 12 months? I would say that we are already in a weak economic situation and we expect that weakness to continue.

As a result, I think the ECB is done tightening and looks set to cut rates, probably cautiously initially, given that they want to make sure they win this fight against inflation. But rates are certainly on the way down from our perspective.

Charles Watford

I think with that backdrop, credit looks an interesting opportunity. First of all, the starting leverage, the starting conditions for the majority of investment grade and high yield companies are in good places. So leverage is low. There's been a lot of preparation for a recession on the corporate side for really the last two years, and you can see that in the high yield market where 65% of bonds are rated BB versus only 5% rated CCC.

The second point I think is important, is that we are seeing more credit rating upgrades than downgrades in this environment and growth has been weak last year as well. And it's really because corporates in this higher rate environment are taking the decision to deleverage, to reduce their cost of debt and reduce the amount of debt - and again, that's positive for a lot of companies, BB's for example going to investment grade.

Nicola Mai

One of the questions, obviously, that we get asked a lot is what does this macro outlook mean for markets and European bond markets specifically? And in that context, I would say that European interest rate risk here looks very attractive. You know, we have the highest level of yields we've seen in over a decade.

And I think history suggests that there is a high correlation between the level of yields and the returns on fixed income. So I think this is a very good starting point. And maybe the final point I would make is that cash has been king, you know being in cash has been great, but yields in cash are fleeting. They're high today, they're probably not going to be high tomorrow - so I think it is time to lock in some of these yields by adding some duration exposure to portfolios.

Charles Watford

Absolutely, and as you say, as investors move out of cash into other areas of the fixed income market, to earn better returns and more duration, investment grade credit is one of those areas that will benefit and also the high quality elements of the high yield market.

We can also see that despite what's been a good performance for credit in 2023, those valuations that you mentioned are still attractive.

A lot of companies, investors and management teams have been expecting a recession and a slowdown since as soon as the central bank started hiking rates. As a result, some of that risk premium of a recession is already in the markets, which therefore means that as an investor today, you are getting some compensation for that.

Nicola Mai

So, yeah, Charlie, when we think about European credit markets and portfolio positioning over the next year, my thoughts would be that credit markets are attractive here. You know, spreads are not particularly wide, you know, from a historical perspective, but the overall total return of the credit markets looks interesting to me.

Charles Watford

So if you look at where we're positioning portfolios at the moment, we find a lot of opportunities in credit upgrade candidates - so BB’s moving to investment grade where you can achieve 100 basis points of spread compression, which can give very attractive total return opportunities. The second area that we also see as attractive is those shorter maturity bonds.

And finally, from an asset allocation point of view, European high yield has provided better risk adjusted returns than the main European equity indices over the last 20 years, and so now with starting yields where they are, we have the potential to continue that over the next five years.

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The views and expectations expressed are those of the authors. There is no assurance that the opportunities identified above will materialize or that the Investment Opportunity will achieve its investment objectives and provide any level of returns. There is no guarantee that these trends will continue.

Statements concerning financial market trends are based on current conditions which will fluctuate.

General Risks:

• Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.
• Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.
• Investing in foreign denominated and/or domiciled securitiesmay involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.
• Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.
• High-yield, lower-rated, securitiesinvolve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.
• Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value.
• Mortgage and asset-backed securitiesmay be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations.
• Entering into short salesincludes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio.
• Derivativesmay involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
• Diversificationdoes not ensure against loss. 

Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the US government. Certain US government securities are backed by the full faith of the government. Obligations of US government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value.

Past performance is not a guarantee or a reliable indicator of future results. There is no guarantee that any forecasts, projections or targets will be achieved. All investments involve risk including possible loss of capital. 

CHARTS

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OPINIONS

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OUTLOOK

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

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