Balancing Objectives 1: Income Generation

Around the Curve

Balancing Objectives 1: Income Generation

Embracing a global opportunity set can help bond managers seek attractive, stable income, as illustrated by several examples from Brandywine Global in recent years.


The post-global financial crisis (GFC) investment climate has been characterized by periods of financial and commodity market volatility, and the steady decline in G10 bond yields. Developed market bond yields have remained persistently low over the last few years, with several recently retreating into negative territory. This environment has presented challenges for investors who are interested in risk-adjusted income opportunities.

We believe a fixed-income portfolio can provide attractive, stable income and capital preservation if one considers a global opportunity set. The ideal approach must be flexible, aware of relevant risk benchmarks, and allocate to opportunities in a more significant and focused manner when they present themselves.

Perhaps the best way to understand the process is to review where we have found risk-based opportunity during the last 10 years. Markets have been punctuated by many mini-slowdowns and recession scares over the past decade, yet these periods may be value opportunities for income-oriented investors.

Two specific examples highlight the specific opportunities we found:

  1. The European sovereign debt crisis and the subsequent repricing of European and U.K. credit relative to the U.S. and
  2. The energy sector revaluation throughout 2015 and early 2016.
     

The European Sovereign Debt Crisis

Let’s examine the European sovereign debt crisis from 2011-12 first. European policymakers did not respond to deteriorating economic conditions quickly enough and corporate credit yields rose alongside sovereign bond yields, though not to the same degree as during the GFC. At the time sterling- and euro-denominated corporate credit offered  the best value relative to U.S. corporate bonds.

Our stance was concentrated in the European high yield credit market, particularly issuance rated single-B and BB. European credit spreads compressed after the European Central Bank (ECB) pledged to do “whatever it takes.” Two years later, in 2014, the central bank implemented its asset purchase program, which significantly compressed credit spreads even further.

Chart 1 and Chart 2 highlight the valuation anomalies relative to history and the multi-year value opportunity that we were able to focus upon.

 

Charts 1 and 2 Sources: Bank of America Merrill Lynch / Bloomberg. Verical axes represent basis points. See Definitions below for definitions of abbreviations. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment

 

The U.S. Energy Sector

Now, let’s examine the U.S. energy sector from the opportunity presented in 2015-16—which became particularly opportunistic in early 2016. Following the collapse in crude oil prices over the prior two-year period, spreads on high yield credit in the energy sector topped 500 basis points versus investment grade corporate bonds. We chose to focus on better quality segments of the U.S. energy market. Spreads compressed significantly due to industry consolidation, low cost of borrowing, and the eventual recovery in crude prices.  Chart 3 and Chart 4 again highlight the historical valuation anomaly and the opportunity across the quality  spectrum.

 

Charts 3 and 4 Sources: Bank of America Merrill Lynch / Bloomberg. Vertical axes represent basis points. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment

 

Next week will examine how this approach reduces volatility at the portfolio level and broadly minimizes correlations with other asset classes—which are notable components of our capital preservation efforts


Definitions:

The Group of Ten (G10) is made up of eleven industrial countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States) which consult and co-operate on economic, monetary and financial matters.

An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. 

A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.

A basis point is one one-hundredth (1/100, or 0.01) of one percentage point.

A spread is the difference in yield between two different types of fixed income securities with similar maturities; usually between a Treasury or sovereign security and a non-Treasury or non-sovereign security.

Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.

The following refer to the horizontal axis labels on Chart 2.  Letters (B, CCC, etc.) refer to credit ratings:

GHY Global High Yield

GBB Global BB

GB Great Britain

GCCC Global CCC

USHY U.S. High Yield

$BB U.S. Dollar BBB

$BB U.S. Dollar CCC

CAD HY Canadian Dollar High Yield

CAD BB Canadian Dollar BB

CAD B Canadian Dollar B

EHY Euro High Yield

£HY British Pound High Yield

£BB British Pound BB

£B British Pound B

£ British Pound CCC

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Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

A credit rating is a measure of an issuer’s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor’s, Moody’s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.