Yields on bonds are outstripping yields on equities for the first time in a generation, with bonds likely to deliver attractive returns going forward despite heightened recent volatility, according to Daniel Saldanha, portfolio manager and head of credit and fixed income at Income Asset Management.
“For the first time in 20 years, ten-year treasury bonds are offering similar yields to the earnings yield on the S&P500, which offers a fantastic opportunity for fixed income and credit investors. Valuations matter – with the S&P 500 earnings yield at five per cent, profit growth needs to be materially above current consensus for the S&P 500 to deliver an eight per cent to ten per cent return per annum over the next three years, which will be difficult to achieve,” he said.
“The level of return on high yield credit is mirroring the returns typically expected of the S&P500. The 7-10 per cent p.a. return profile available in credit markets looks much more certain than the same return in equity markets. Credit investments benefit from contracted coupons, security and fixed maturities, and it is rare for credit spreads to be higher than the equity risk premium”, according to Mr Saldanha.
“Moreover, while bond default rates are likely to rise, we don’t expect they will hit the peaks experienced during the GFC. Every serious credit investor is already pricing in defaults, and while they will increase globally, investors are currently being paid attractively for default risk in credit markets.
“It would be highly unusual to see a default cycle with broad based profit growth in public companies and no severe multiple compression. For context, an investor who invested in S&P500 in July 2008 would have been materially worse off, over a three and five-year basis, than a high yield investor who invested at the same time. This is despite high yield going through the worse default cycle in its 42-year history.
“While lower quality companies financed with high leverage will face stress – and many will default – the vast majority of the credit market will continue to pay coupons and be repaid. There is considerable dispersion in quality in high yield markets and we think quality credit is undervalued.
“As a result, we have conservatively positioned the portfolio to more defensive investments over the last six months. Safety matters and you can preserve capital and deliver attractive returns by opportunistically investing in mispriced high-quality bonds,” he said.
The high-yield and leveraged loan markets have shown impressive resilience, with only seven years of negative returns over 42 years. According to JP Morgan, the US high-yield bond market has generated 75 per cent of the return on the S&P 500, with half the volatility over the last 25 years. In addition, BB-rated high yield bonds have experienced a less than one per cent average default rate.[1]
The IAM Global Credit Opportunities Fund – lead managed by Mr Saldanha – provides investors with exposure to a diversified portfolio of global credit investments, hedged into Australian dollars. The Fund’s objective is to generate total returns of eight to 10 per cent per annum over a three-year horizon. The Fund is currently yielding 10.4^ per cent to maturity, with a weighted average life of 3.3 years and is heavily weighted to senior secured.
[1] https://incomeam.com/global-credit-opportunities-fund/
About Income Asset Management
Income Asset Management is an ASX listed group (ASX: IAM) that delivers a complete income investment service. We aim to provide investors, advisers and portfolio managers with the most trustworthy and capable platform to research, execute, and manage their income investments.
With a wealth of specialised industry experience and with more than $3 billion assets under administration, our business covers a broad spectrum of income investments including cash deposits, bonds and Funds Management.
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