The ongoing low interest rate environment has forced investors to take more risk as they look to move away from cash or risk-free assets in order to meet the return targets in their overall portfolios. “Everything looks cheaper on a relative basis to turning zero for your cash or even your risk-free assets, and you can stay there when you’re really worried, but that can last for short periods of time (as during the Covid outbreak) and we seem to be emerging from that already,” said Timothy Paulson, Investment Strategist at Lord Abbett & Co., at Pensions & Investments’ Fixed Income & Credit virtual series. “There’s a very large amount of buying power out there, which we’ve seen a glimpse of in September, October and heading into the election, with little spasms of the market trying to sell off,” he said adding “The positive news around a vaccine from Pfizer is really a game changer. If nothing else, it may be an inflection point in this cycle of the Covid pandemic.”
Selective Opportunities in Credit for Investors Ready to Move
As investors consider where to invest in the fixed income and credit markets, the macro picture is one of a K-shaped recovery with a tale of two economies, said Paulson. One is the more tech-based and the more innovative names in the growth universe that continue to do exceptionally well, while the other is the more cyclical industries and those based on crowd activity that have been declining, he said, at the session titled, ‘Risk On? What Strategies are Providing the Best Opportunities and How to Set Parameters.’ “If you look at valuations, you want to determine if those companies can survive? What will be different as we emerge from Covid? Valuations look really, at least based on historical levels, quite compelling, even if you bake in some stresses and potential defaults,” said Paulson.
“If you look at double B credit spreads, which is a nice proxy for quality high yield, before the Pfizer vaccine announcement, they were around 340, 350. We saw those levels at the end of February last year, when people were already getting nervous. So it does indicate there's still trepidation with which investors are approaching the market, the cash has not yet really come in and driven up valuations,” noted Paulson. While the optics of the S&P are driven by a few mega-cap tech stocks, it doesn’t really focus on a lot of value stocks or distressed industries which still face a lot of challenges, he said.
“When you look at the tremendous amount of cash on corporate balance sheets, corporations have really taken advantage of the incredible liquidity to build war chests for this uncertain environment over the next couple of years. They’re not focused on optimizing earnings or return on equity, they're focused on navigating a less certain environment, which is wonderful for bond holders,” he pointed out. The market has come through a flood of defaults, and that was not a surprise in the most vulnerable industries like energy, retail and other stressed areas, he noted, adding that should not make investors wary of taking a selective approach to corporate credit.
In the high-yield universe, where a lot of the weakest companies had been culled from the herd in the first half this year, there now are a number of ‘fallen angels,’ said Paulson. “That includes names like Kraft Heinz and Ford Motor company. Are we really worried that consumers are stopping with their ketchup and American cheese? No. Kraft Heinz was downgraded because it chose to not cut dividends. It’s not that the credit risk has gotten worse, it means the credit quality for those investors is much better and yet the spreads aren't that much tighter,” he said.
With the positive news of the vaccine developments, “we know that some day there'll be a return to normalcy, and lenders will become much more willing to extend credit to those more marginal borrowers. What that really means now is that the compelling opportunities are in the areas that, a month ago, people thought were toast, like cruise lines, airlines and hotels. There’s clearly pent up demand for people to travel, and while it won’t happen all at once, it is likely to play out and there’s still a lot of return potential in those areas,” Paulson said.
“I want to caveat that by saying what my first boss in the business drilled into my head, ‘There is no such thing as a bad bond, only bad prices.’ So it's always about relative valuations,” Paulson said. Sectors like airlines and hotels are so distressed that you can find credits in these industries that have become interesting, he said.
“When you think about investing in the pandemic period, there are different narratives. One is when it's just generic risk off and everyone's selling, so you can focus on finding quality areas that may have cheapened because everything has cheapened,” he said, adding “Then, as prospects have changed and certain valuations have lagged, these become interesting areas.” Energy, however, is one area which still faces potential regulatory headwinds for oil companies and capital availability concerns. “So you certainly have to be very cognizant of all the market dynamics, but there clearly is opportunity and there are compelling valuations in high yield, in commercial mortgages and in asset-backed securities,” Paulson said.
For investors who may be wary now about putting cash to work with the Covid resurgence, Paulson cautioned they may miss some of these current market opportunities. “While it’s wonderful to be able to wait for the perfect time, markets tend to be extremely forward-looking. Our thesis is that we really have reached some kind of inflection point with the light at the end of the tunnel, and it is probably time to get ahead in some of these areas,” he said.
“If you find companies that do have the reserves or the assets to ride things through, you're probably going to get some opportunity there. If you can capture some of that illiquidity premium in the more private credit areas, that’s an opportunity,” he said. “When you look at commercial mortgages, where things were distressed, there’s a lot of room there and you want to be in earlier rather than later.” Another area he recommended is hard currency emerging market debt, where returns are tied to long-term growth prospects in countries showing the strongest growth results in the world today.
“The big issue structurally is that there’s too much debt in the world, which will be a drag on future growth. But in the short term, it also leaves us to be less resilient in the face of shocks,” Paulson said. “While fixed income can be a ballast in the portfolio, if we enter an environment where inflation starts picking up, it can destabilize every portfolios.” Investors need to carefully watch monetary and fiscal policy and the implications on interest rate movements, he added. “There’s no easy answer, and it’s certainly not a smooth, straight ride.”
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