PHILADELPHIA, April 29, 2015 /PRNewswire/ -- With interest rates at or near historical lows worldwide, fixed income investors want alternatives to lower-than-low return government bonds. This search for greater yield has drawn increased attention to high yield credit. Yet after six years of stellar returns, dearer valuations are forming pronounced pockets of risk for investors in passive or regionally restricted strategies.
Where can investors find value and avoid risk within global high yield markets?
Brandywine Global's Gary Herbert, portfolio manager of the Brandywine Global Alternative Credit Strategy and Brandywine Global High Yield Strategy, believes Europe offers the best combination of value and improving fundamentals.
"European high yield credit and high yield mortgage risk premia are attractive investments for those who believe Europe is entering a positive feedback loop of better sentiment, growth, and reflation," Mr. Herbert observed.
In contrast, he believes U.S. credit is expensive and fundamentals offer limited scope for improvement. Asian and emerging market credit, while not as expensive as the U.S., face a greater chance of negative growth surprises or currency complications in the near term.
Mr. Herbert explained, "U.S. high yield valuation is about one half of a standard deviation rich (or 50 basis points) by our models and the U.S. is much closer to the apex of its credit cycle. Asian and emerging market credits are not expensive, but suffer from a greater potential for deterioration in growth or financial conditions, in our opinion."
Further explaining his funds' active theme of European reflation, Mr. Herbert said, "The European Central Bank's balance sheet is again growing while the Fed's will most likely be static. European large-scale asset purchases have begun in earnest with targets of sovereign, agency and asset-backed debt. These reflationary efforts will keep core euro-zone safe-haven yields at low or negative levels. Even shorter-term debt yields from peripheral countries, like Spain, are negative."
"At the same time, the euro has depreciated, improving competiveness and terms of trade. Negative nominal interest rates, improving confidence and cheaper currency resulting from central bank stimulus present an excellent backdrop for Europe to reflate and credit to perform well."
European reflation may be in its nascent stages, but European financial markets are already gaining strength.
"The rapid pace of forced European deleveraging has stopped," Mr. Herbert observed. "Bank activity is crucially important in Europe, where banks represent a much larger portion of lending relative to capital markets than in the U.S. Markets seem to agree that banks are done deleveraging, reflected in tighter credit spreads and improved equity valuations. This should encourage credit disintermediation to take place. Capital markets are starting to play their proper role in Europe."
Credit disintermediation is an important force for more efficient capital allocation in Europe, but the trend also benefits investors. Agile, globally flexible investors with proprietary research platforms can seek new-to-market issuers that must offer additional compensation — higher yields — to overcome market participants' unfamiliarity with them. Many European issuers that traditionally had bank-debt-only capital structures are coming to market with bonds.
"Owning the right credits that emerge as a means of disintermediation can be lucrative," Mr. Herbert said. "The opportunity to earn idiosyncratic alpha through security selection continues to improve with greater credit disintermediation."
Although rigorous bottom-up research is a must for any active credit strategy, a top-down perspective is the most crucial factor in assessing high yield opportunities. According to Mr. Herbert, "The last six years offered enough bouts of systemic volatility in credit markets for investors to see the potential benefits of active approaches that offer bulwarks of risk management and downside protection characteristics."
Starting in 2011, European sovereign-debt concerns weighed on European high yield among other markets; the 2013 taper tantrum stressed emerging market credit and currencies; and in 2014 a confluence of Fed rate hike fears, oil price declines (that impacted 15-20 percent of the U.S. high yield universe) and growth concerns in many emerging markets widened credit spreads globally.
Mr. Herbert suggested that investors should find a manager who has performed well in both up- and down-market environments during the prior cycle.
"Demonstrating a record of success in both up and down markets is inherently more repeatable than demonstrating superior upside capture alone," Mr. Herbert said. "Investors should seek strategies designed to manage through entire credit cycles, not just outperform in up markets."
"The greatest truth in managing credit is yield hogs proverbially get slaughtered – over and over again – in every significant recession and economic shock."
Managing through cycles requires an effective combination of top-down perspective and bottom-up research.
"Maintaining a broad opportunity set, and patiently rotating into sectors and regions with attractive value, is the best way to manage through entire market cycles," Mr. Herbert advised. "Credit mandates with tight restrictions on sectors or regional allocations, like those dedicated only to U.S. credit opportunities, or corporates, have fewer opportunities to avoid risk and seek value."
The firm's Global Credit strategies have the flexibility to invest across any region and all higher-yielding sectors within those regions. This includes but is not limited to corporates, securitized and structured debt, currencies and emerging market debt.
"Purchasing undervalued securities, with the benefit of a capable research platform combining top-down and bottom-up analysis, can effectively control risk and deliver attractive returns," Mr. Herbert said. "Strategies that only employ bottom-up approaches, or are index-replicating, are insufficient in our view. They add unnecessary risk to the portfolio management process."
As for his outlook on global credit markets in the next few years, Mr. Herbert was cautiously optimistic.
"Credit risk premia are much slimmer in 2015 and must be carefully managed, but many variables still provide an attractive backdrop. G3 policy rates will take a shallow path higher and ultimately terminate at low levels. Global growth should be weak, but not terrible. Major systemic risk should be drowned out by active central banks. All of these environmental variables are positive for credit."
One risk remains palpable, but is not necessarily imminent: volatility will likely increase as global growth incrementally improves and central banks get less aggressive on managing outcomes. Mr. Herbert handicaps those events as potentially further out than investors expect.
"That renormalization process may take a long, long time. Being long credit still makes sense, but diminished overall value will require investors to be smarter about the credit risks they take."
About Gary Herbert
Gerhardt (Gary) P. Herbert, CFA is a portfolio manager for Brandywine Global's fixed income group, with a concentration in high yield securities. Mr. Herbert joined Brandywine Global in March 2010, bringing with him over 20 years of high yield experience. Previously he was a managing director, portfolio manager with Guggenheim Partners, LLC (2009-2010); a managing director, portfolio manager with Dreman Value Management, LLC (2007-2009); and an executive director, portfolio manager (1999-2007) and associate (1994-1998) with Morgan Stanley Investment Management. Mr. Herbert earned a M.B.A. with honors from Columbia University, and a Bachelor's Degree from Villanova University. He holds a Chartered Financial Analyst certification and is a member of the Philadelphia Scholars Program Investment Committee.
About Brandywine Global
Founded in 1986, Brandywine Global Investment Management offers a broad array of fixed income, equity, and balanced strategies that invest across global markets. As of March 31, 2015, Brandywine Global manages $66.5 billion in assets. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. (NYSE: LM), and is headquartered in Philadelphia with an office in San Francisco. Brandywine Global also operates two affiliated companies with offices in Singapore¹ and London².
1. Brandywine Global Investment Management (Asia) Pte. Ltd.; 2. Brandywine Global Investment Management (Europe) Limited is authorized and regulated by the Financial Conduct Authority (the "FCA"). (FRN 472774). Registered in England and Wales, No. 06324517
About Legg Mason
Legg Mason is a global asset management firm with $703 billion in assets under management as of March 31, 2015. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).
Investments in fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. An increase in interest rates will reduce the value of fixed income securities. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Asset-backed, mortgage- backed or mortgage-related securities are subject to prepayment and extension risks. Risks of high-yield securities include greater price volatility, illiquidity and possibility of default.
The views expressed are those of the portfolio manager as of the date indicated, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Securities and sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision.