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Gauging the Pain Threshold

14 November 2018 by Eoin Walsh

A quick look at the dashboard of 16 fixed income indices I track clearly shows the amount of pain experienced by investors so far this year. Of the 16 indices I follow, which include IG corporates, government bonds and high yield all denominated in sterling, euros and dollars, Bank CoCos, £ and € Sub Insurance, three hard currency corporate EM indices and the G7 govvie index, only two had a positive total return for the year at the end of October. The worst performing, since you ask, was € Sub Insurance at -3.86%.

One of the two bright spots was the dollar HY index, which probably won’t come as a surprise. The other, which was also the best performing of the 16 mentioned, probably will – we’ll get to that later.

Looking back on the year, markets have obviously had plenty to deal with; heightened geopolitical risks, an unpredictable US president, EM volatility and idiosyncratic risks in countries including Brazil and Turkey, political instability in Europe and, last but by no means least, the Fed pushing ahead with rate hikes, contributing to a flattening yield curve and a strong US dollar. However, contradicting all of this has been the relative strength of economic fundamentals. We have enjoyed slow but non-inflationary growth, which normally suits credit risk, and very positive rating migration with upgrades easily outpacing downgrades in both the US and Europe (this is obviously backward looking, but then so is this blog). In addition, from the bottom up, it’s worth highlighting three quarters of decent earnings, even if Q3 didn’t quite live up to previous quarters with a slight increase in the number of companies missing estimates.

So despite the fundamentals, investors have taken a lot of pain, with some very big moves in various sectors within the credit universe. So the obvious question being asked, to paraphrase a famous long term investor, is should we start being greedy, or continue to be fearful?

I can’t answer that, but it does take me back to the best performing index from my dashboard, which surprisingly was the £ HY index with a total YTD return of 1.6%. How, with Gilt yields moving higher (the Gilt index is -0.51% over the same period), and with the asset swap spread of the £ HY index widening by over 100bp to 454bp, and with the yield on the index going from 4.6% to just over 6%, is this possible?  Well, quite simply, if you start with a relatively high yield, you can take a lot of negative price moves and still produce a positive total return due to the coupons you are accruing.  The Euro HY index is a useful comparison. It has also experienced spread widening of around 110bp, but only had a starting yield of 2.67% and has therefore returned a negative 1.3% over the period.  The worst-performing € Sub Insurance index mentioned above started with a yield of just 1.7% and a spread of 166bp – not much room for negative news!

Deutsche Bank also produced some interesting statistics at the end of October, which showed that some 89% of assets included in its annual long-term study had a negative total return so far this year in dollar terms, the highest percentage recorded based on data going back to 1901!  By comparison, 2017 was the best year, with only 1% of assets finishing with a negative return.

We started the year with some very low yields, thanks to a fantastic 2017 for credit, and since then, we’ve seen a lot of repricing.  Timing the markets is notoriously difficult but there is a lot of bad news in the yields currently, and as we can see from the £ HY index, when you build in bad news, you can take more and still be positive for the year.  Food for thought if you are sitting on cash, and certainly worth considering if you have stayed invested and have already taken a lot of pain.

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