High-quality credit returns to center stage

Investment-grade credit is having its moment in the spotlight, thanks to a potent combination of central bank action, a search for yield and the recognition that conservatism in investment is key.

Sources at money management firms and consultants said there has been a rotation out of government bonds and inflows into investment grade, with the U.S. the shining light when it comes to opportunities.

“There is a prestige right now for the market around high quality — it is investment grade's time,” said Andreas Michalitsianos, portfolio manager in London at J.P. Morgan Asset Management. “Investment grade, in the U.S., Europe, and now in the U.K., is caught in the crosshairs between being in the central bank toolkit and being a risky asset.”

The case for investment grade was bolstered when the Bank of England's monetary policy committee announced Aug. 4 that it would extend its measures to stimulate the U.K. economy in part by buying up to £10 billion ($13.1 billion) of corporate bonds.

“It is a golden rule ... that you want to be buying what central banks are buying,” said Tapan Datta, head of asset allocation in London at Aon Hewitt. “And they are buying investment grade.”

The fact that corporate bond buying is happening in Europe and the U.K. is not important; globally investment grade is strong, he said.

Central banks in the U.K. and Europe also are helping support the U.S. credit market, added Gregory Venizelos, senior credit strategist at AXA Investment Managers in London. “Investment grade was not exactly the favorite child in terms of investor preference at the beginning of the year, but things have changed. A low zero- and negative-rate backdrop globally, plus activity by the Bank of England and (European Central Bank), has boosted the prospects for investment grade.”

Added Mr. Michalitsianos: “I think we are seeing structural flows. The Fed is not buying corporate bonds, Bank of Japan is not buying U.S. corporate bonds — but this rebalancing effect (of) bringing cash rates into negative territory in Japan and Europe has caused, whether it is a coincidence or not, a surge in demand for U.S. investment grade.”

Figures from data provider EPFR Global tell the story. For 2016 through Aug. 8, investment-grade funds have attracted $97.8 billion, compared with net inflows of $55.1 billion for all of 2015. That marks a significant turnaround compared with 2013, when net outflows totaled $88.7 billion for the year.

“It is a bit of feast or famine for investment grade in the sense that we are seeing significant inflows as part of a search for yield and income,” said David Riley, head of credit strategy at BlueBay Asset Management LLP in London. “There has been a rotation out of government bond funds into credit, in particular investment grade, and we are also seeing more broadly outflows in Europe from equity funds and into fixed-income funds — certainly into credit, and investment grade being the primary beneficiary of that.” Overlay those elements with central bank action, and there has been a rally in credit spreads, he said.

Sources placed the spread pickup for investment grade around 200 basis points. U.S. investment-grade opportunity shines particularly bright when it comes to yield, they noted. Other managers pointed out opportunities in Asian investment-grade credit.

“In a world where yield is not just scarce, but unavailable, if you look at long-duration investment grade in the U.S., you are still getting a pretty reasonable yield because the U.S. still has some government bond yield left — albeit very squeezed,” said Mr. Datta. “On top of that, there is a fairly decent spread of around 2%. All in all, if you are picking up a 4%-plus yield from an asset class which central banks globally are buying, and you want to hedge some of your interest-rate risk, you can do a lot worse than holding U.S. investment grade.”

And there is enough to go round - the U.S. investment-grade market is roughly $6 trillion - three times the size of the eurozone market, noted BlueBay's Mr. Riley. “If you are a large European or Japanese or sovereign wealth fund investor, and still want to be relatively conservative, want some liquidity and have relatively large amounts of money to put to work, U.S. investment grade ticks the box — it is big, relatively liquid and even though we are mid- to late in the U.S. credit cycle, unless you make a big mess-up in terms of credit selection, you shouldn't be incurring outright credit losses,” said Mr. Riley.

Aon Hewitt has encouraged clients to keep U.S. investment-grade holdings they might already have, because of the “still decent” credit spread, said Mr. Datta. The consultant's notion on long-term fair value is 1.5% to 1.75%, he said, “and you are getting 2%.”

Sterling investment grade is yielding less than 2%, while European investment grade is offering investors less than 1%, said sources.

“The issue in Europe is how low those yields are,” Mr. Datta said. “And an additional risk is that a lot of what you are getting is now credit spread here, as there is not the government bond underneath it. The thing that worries me is if conditions deteriorate, you are taking a lot of credit risk. That brings a different kind of risk to consider.”

And risk is on investors' radars.

“Usually when you have got an OK macro outlook, you would have managers saying "overweight high beta, high yield, subordinated debt,' looking for more yield in the universe. But I think the case is, it is all about quality — high-quality, high-grade income. I think (investors) are playing safer, and if there is a hiccup in growth (they) are playing closer to the central banks,” said J.P. Morgan's Mr. Michalitsianos.

“After Brexit, the world has not collapsed so people need to move on — but at the same time investors nowadays are very cautious, and try to be more conservative,” said Arthur Lau, Hong Kong-based managing director, co-head of emerging markets fixed income, head of Asia ex-Japan, fixed income, at PineBridge Investments. “So fixed income seems to be a better place to hide.”

Still, risks remain. AXA's Mr. Venizelos said that “at least half the return of an investment-grade portfolio in developed markets indices is because of rates — about 30% to 40% is because of credit spread compression.” Therefore, an uptick in inflation in the U.S., leading to any unexpected interest rate hikes, could reverse some of the returns so far this year. However, with sterling investment-grade returns hovering around the 16% mark, rates moving up and taking out a few percentage points of returns would not be the end of the world, said Mr. Venizelos.

Kathleen Gaffney, co-director of diversified fixed income at Eaton Vance Corp. in Boston, said she doesn't see value in investment grade.

“In fact, I see a tremendous amount of risk. We really are in uncharted territory with negative yields. I think there is a lot of complacency — one, that fundamentals are OK, but two, that the central banks are going to continue with low rates for a longer period of time. That lower-for-longer mindset really forces investors to look for yield in what they perceive to be safe places — but safety is not always as safe as it appears.”