Goldman Sachs Asset Management’s Jeremy Cave suggests where investors should look to find credit investment opportunities.
Action points
Increase investment grade exposure
Look beyond the domestic market for credits
Make risk mitigation part of the strategy, not an afterthought
Donald Trump’s priorities are highly uncertain, but plans for regulatory relief, tax reform and infrastructure spending will have an enduring effect on some sectors.
Which sectors for credit investment?
Bank stocks rallied by more than 10 per cent in the first few days following the vote, prompted by expectations that a Trump presidency will see an unpicking of regulation in financial services, and the energy industry is likely to see a similar benefit.
With UK and US monetary policy likely to diverge, the cost of a full cross-currency basis swap hedge is worthwhile
Should expectations of tax reform be fulfilled, there could also be an effect on pharmaceutical and technology companies as they repatriate the large cash reserves they hold offshore.
Benefiting from these developments – if they materialise – will require a thoughtful approach to their effect on individual credits.
Exploration companies in the energy sector might find a loosening of regulation a mixed blessing if the oil price falls, while pipeline firms would benefit.
The pharma and tech industries could benefit from corporate repatriation legislation, as the return of capital to their domestic balance sheets may have the bondholder-friendly effect of reducing companies’ tendency to increase debt to fund dividends or share buybacks.
Reconsider your portfolio strategy
The immediate backdrop aside, our long-term view on opportunities in global credit for UK pension funds, many of which are confronted by sizeable deficits and are now cash flow negative, remains unchanged.
Schemes must look again at the traditional approach of combining a liability-driven investment strategy with a growth portfolio. While the rationale of that strategy – high-quality investments such as gilts and swaps on one hand, riskier assets like equities and real estate on the other – is obvious, it is an uncertain means of closing the funding gap.
A better alternative exists. Investment grade credit offers stable cash flows: if funds can replace a proportion of their LDI portfolio with a cash flow matching strategy using corporate bonds, over time they can address the deficit by harvesting the credit and illiquidity premia this market offers.
Of course, this approach has its own limitations. Few corporate issuers borrow in the maturities institutional investors require to match their longest liabilities, so they should only partially replace LDI assets.
Investors taking this approach could build a cash flow matching portfolio with a higher yield and more predictable return than the traditional approach.
There are also risk implications: while the investment grade market carries a low probability of default, downgrade risk is relevant and over time this increases. A prudent approach is to assess downgrade probabilities and incorporate a haircut to cash flows during the investment period.
Look to the US for opportunities
The greatest range of opportunities is currently in the US credit market. The central bank bid for investment grade bonds continues to depress yields in both the UK and the eurozone, where they are eligible for quantitative easing programmes.
The US offers a large and diverse range of non-financial BBB-rated issues, with up to a 50 basis point premium over the 220bp spread sterling investors can expect at the 30-year point of the curve.
DB taskforce encourages credit innovation to tackle deficits
Finding solutions to the defined benefit funding crisis will require the pensions industry to “challenge conventional thinking”, the chair of the Pensions and Lifetime Savings Association’s new DB taskforce has said.
Taking advantage of this requires a further risk management provision, however: investing in US corporates would give sterling investors exposure to both the dollar and the US interest rate curve.
A straightforward foreign exchange hedge would only mitigate one of these risks, so scheme managers should incorporate a full cross-currency basis swap into their portfolios. With UK and US monetary policy likely to diverge, the cost of this hedge is worthwhile.
Building cash flow matching portfolios based on sound credit selection, underpinned by prudent risk management, offers UK schemes their best hope of addressing the deficit problem.
Jeremy Cave is managing director at Goldman Sachs Asset Management
