Central to investment decisions is the question of risk. We make decisions on imperfect information and assess the potential reward and risk all the time. The Oxford AstraZeneca vaccine highlights the issue – but on a greater scale.
We think we know that the vaccine lowers the chances of catching Covid and reduces severity. But there is some evidence that it increases the risk of blood clots. So, what does the government do? They make a risk-based assessment and determine whether one set of risks outweighs another. The difficulty they face is that deaths from blood clots will be recorded but excess deaths from not using the vaccine will be indeterminant. Leaders need to see the bigger picture.
Thankfully, the investment choices I make are not life and death decisions. Nevertheless, the process is the same – weighting probabilities, assessing potential outcomes and looking at downside risk against potential reward. I have been doing this for over 30 years in credit markets and over that period it is remarkable how investors have been able to harvest a long-term return premium over government bonds from sterling credit markets.
In the early 1990s there was not much of a sterling credit market to talk about. Bonds were issued at a spread and barely moved from those levels unless there was a specific credit event. As the market widened and deepened there was more choice and by the mid- 2000s sterling credit and gilt markets were of roughly equal size. However, credit spreads had not changed significantly – with an average of 50-60bps over gilt yields being the norm. In the run up to the financial crisis and over subsequent years things changed a lot – with a peak spread of 4.5% being seen in March 2009. Since 2011 volatility has been higher with a credit spread of 1%-1.5% covering most periods. Over the longer term, the compensation needed for default risk (relative to the risk-free rate) has not changed a lot and for investment grade bonds is well below 40 bps. So, what is it that made investors so nervous of credit bonds – why was risk assessment imperfect? Well, the characteristics of credit have changed – notably more leverage and more BBB rated bonds in indices. In addition, faster business model obsolescence, the psychological legacy of the financial crisis and shifting credit agency methodologies have also contributed to caution on the asset class. But I think the answer is that it is too easy to look at individual bond risk without considering the merits of an asset class: the medium-term benefit of compounding excess yield (relative to government bonds). As long as risk is sufficiently diversified credit markets have offered a pretty reliable source of excess return relative to government bonds. In effect this sums up my approach to credit management: take a yield advantage, diversify risk, invest for the medium term, and assess the wider view.
Cash, government bonds and currencies
Cash rates drifted lower for choice over the week and sterling declined against both the US dollar and euro.
The outlook for growth and inflation remained the key topics. Interestingly, over the week, implied inflation fell back from recent highs. In the US breakeven inflation at the 20-year point fell by 5 bps whilst in the UK the drop was somewhat larger at 8 bps. Overall, growth prospects seem pretty unchanged with expectations of a strong 2021 outcome in the US a consensus view.
In the UK, the PMI Composite arrived in line with expectations. The surprise was in Construction with a sharp increase over the month to 61.7, a 6 ½ year high; this reflected strong housing and logistics development. The RICS House price balance also showed an upward surprise. UK governments, particularly Conservative-led ones, have been keen to support the housing market at times of economic turbulence. This makes it unlikely that the UK will follow the example of New Zealand where the central bank’s remit has recently been amended to explicitly consider house price inflation. Clearly, some inflations are deemed more desirable than others.
10-year US government bond yields moved marginally lower to 1.65% with longer dated yields moving broadly in parallel. The UK took its lead from the US, but Europe bucked the trend with yields rising (becoming less negative in the case of core Europe).
Sterling credit spreads were broadly unchanged again. One new issue especially caught my attention: a secured five-year bond issued by Gatwick Airport. It was not a large issue with £450m being sold into the market. However, the book size was over £3bn even when the spread premium moved in from an initial starting point of 2.1% to an issue level of 1.8%. The bonds are now trading at 1.7% over gilt yields.
I think this is illustrative of market conditions – last week it was easier to sell than buy but in previous weeks the balance was more even. What we know in credit markets is that it does not take much for sentiment to tip.
Global investment grade markets were relatively uneventful while in high yield, spreads reversed recent widening and are now at lows for the year.
Overall, performance across our credit range in Q1 was strong on a relative basis although the rise in gilt yields impacted absolute returns – particularly in all maturity and longer dated investment grade strategies.
The end of the quarter saw Andrew Carter retire from RLAM. I have worked with Andrew for nearly 20 years – most of this time with Andrew as RLAM CEO. I wish him well for the future and would like to thank him for his leadership and support over a period of significant growth.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.