in defence of credit - global · we constantly refer to one of our investment mantras when...

Hermes Fixed Income Quarterly Report Q3 2019

For professional investors only

www.hermes-investment.com

Andrew Jackson Head of Fixed Income

360°In defence of credit

For professional investors only www.hermes-investment.com

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Andrew Jackson Head of Fixed IncomeAs Head of Fixed Income, Andrew leads the strategic development of Hermes’ credit, asset-based lending and direct lending investment teams, and its multi-asset credit offering.

HOW TO HOLD THE LINE WHEN BAD IS GOODIf you’ve tried something for more than a decade everywhere you can, in every way you can, in every place you can, and it has not succeeded – even after cutting rates 700 times worldwide – what should your next move be? Yes, that’s correct, central bankers: try a little more.I have been concerned for several years about the point when monetary authorities admit defeat on their string-pushing strategies and bring out the traditional rate-tightening artillery.

But, if anything, we seem further away from that point of reckoning than we were at the start of the year. That is why markets find themselves in such unusual territory. In our Economic Outlook published earlier this year, we considered how an abundance of cheap money is leading to the ‘Japanification’ of the world economy.

In the fixed-income space, the technical onslaught of this vast and sustained injection of liquidity is nigh on impossible to fight. We’ve seen further evidence of this in recent short squeezes and the ease with which syndicate desks are closing deals that would have been borderline even 12 months ago.

None of this is new or particularly insightful. But at times like this it is worth placing a cold towel on your head and contemplating a few home truths:

�� Central banks do not inject vast amounts of liquidity into markets and inflate their balance sheets to historically high levels when everything is tickety boo;�� $14trn worth of assets don’t have a negative yield in most market conditions;�� Investors will be very hard-pressed to find a yield above 1% from European investment-grade corporate bonds. Less than 4% of all investment-grade corporate bonds trade with a yield greater than 2% and more than 28% trade with a negative yield.

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Figure 1. Global negative-yielding debt, market value, $bn

Strategic opportunities as forces gather

In previous editions, I mentioned the need to balance our own personal biases when commenting on markets – in particular for macro themes. To provide something of a counterbalance to my own weighted positions, here are a few rather less-negative thoughts:�� Credit markets are certainly not poor value relative to other asset classes, despite being closest to the assets that are being hoovered up by central banks. US equity markets, for example, continue to regularly touch new highs, while credit looks cheap versus cash on a multi-year basis;�� In keeping with the ‘bad is good’ theme, it would appear there is a very low probability of this grand monetary experiment slowing down anytime soon – in fact, we may see an acceleration of rate cuts before we see a concerted slowdown;�� There are still signs of good lender discipline in a number of credit-market sectors, suggesting the rally has not yet arrived at the ‘get back in there at once and sell’ stage.

One of the obvious effects of central bank activity through zero interest-rate policy (ZIRP) and quantitative easing (QE) has been to drag the yield and credit spreads of fixed-income assets tighter.

To anyone who either invests in or manages a credit portfolio in these markets, it’s obvious how this process works:�� Central bank A lowers rates;�� Investable asset B lowers in yield as a direct result;�� Assets C to Z reprice as portfolio managers are forced to sell asset B and invest in something with a higher yield to maintain their previous portfolio-level yield;�� The rate cuts cause lower yields on bonds with little discrimination. If the central bank starts QE, it will remove asset B from the market and force portfolio managers to invest in assets C to Z instead.

This phenomenon was clearly seen in the run up to the European Central Bank’s (ECB’s) Asset-Backed Security Purchase Program (ABSPP). Following the ABSPP announcement, the credit spreads of asset-backed securities (ABS) tightened as investors bet that the ECB would soak up the highest-quality parts of this market.

Currently, almost 40% of European covered bonds trade at a more negative yield than the ECB’s deposit rate. Recently, we have seen a raft of headlines highlighting the slew of ‘high yield’ European bonds trading with a negative rate. The pedant in me wants to point out that these issues are therefore not high-yield bonds – but, weirdly, they do carry a below-investment-grade rating.

https://www.hermes-investment.com/ukw/insight/macroeconomics-risk/economic-outlook-japanification/


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Notably, some of the bonds quoted as generating a negative yield do so only because of the nature of the instruments (most being callable). However, a few do appear to fit the description.

Some discipline remains in the ranks

But fearmongering commentators are probably overstating the extent of market distortion caused by the influx of loose credit: not all ships are rising on the tide.

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Source: Hermes, Bloomberg, as at August 2019.

Figure 2. Dispersion of iTraxx Crossover company spreads

Indeed, there are some companies for which even the central-bank gravitational pull – now at almost black-hole conditions – is not enough to tighten their credit spreads.

These firms exist at the outer limits of the credit universe and tend to have either incredibly high levels of leverage, inhabit a sector that is undergoing major stress, or have an idiosyncratic story that makes them almost uninvestable (in Europe, several in the latter category are based in the UK).

Quite possibly, many of the companies that lie outside the influence of central banks could soon escape the atmosphere, perhaps floating off into space to be salvaged by distressed-debt funds.

We have seen an increasing number of these names hurtling towards credit events where recoveries have been well below historical averages. In our view, the rising number of corporate failures is a strong sign that investor discipline is still alive and well; a similar story explains the performance of CCC-rated credits in the US this year.

In the European investment-grade space, the credit-correction effect is slightly less pronounced but, nonetheless, remains apparent with a very small number of corporate bonds generating a disproportionately large amount of the total average yield.

As the chart below reveals, the average yield of European investment-grade corporates is approximately 0.4%. Removing the highest yielding 1.3% of that index would leave the average yield as a negative number (see figure 3).

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Figure 3. Dispersion of European investment-grade corporate-bond yields

Why investors need to keep an active watch

Hermes has long championed the importance of high active share investing. As well as helping us avoid benchmark-related traps, our focus on active share helps maintain investment discipline.

We have embraced the concept of flexible-credit investing as we believe it is appropriate across all market conditions, but the approach is even more relevant in today’s inverted circumstances.

Furthermore, we believe that flexibility allows market participants to avoid some very dangerous traps that the persistent low-interest-rate technical conditions have set for credit investors.

For instance, some investors stick doggedly to a belief that the current yield of their credit portfolio must stay equal to or higher than its target returns, in order to compensate for fees or defaults, or both. But to boost yields in today’s low-rate world, credit investors must inevitably take on more risk by moving down the ratings scale, applying or increasing leverage or including positions that would not be considered in other environments.

Given recent press coverage on the issue of inappropriate positions, I’m a little nervous about commenting on the subject – but that’s normally a sign that I should definitely be addressing it. And our clients certainly care about the topic.

We discussed the potential for liquidity mismatches between the target profiles of portfolios and underlying positions in the latest episode of our fixed-income podcast series, Delta. There have been a number of high-profile cases which have centred around inappropriate underlying positions, rather than just a small mismatch in liquidity.

Liquidity and credit risk are inextricably linked. Of course, all investors must understand both current and future liquidity risks, but the issue is particularly relevant for fixed-income assets.

Credit investment funds must maintain a strong dialogue between execution teams and portfolio managers to keep abreast of the latest technical developments and challenge assumptions about future liquidity.

Prior to the financial crisis, investors failed to challenge assumptions across many areas but their collective unwillingness to question growing liquidity risks was, perhaps, the biggest oversight.

https://www.hermes-investment.com/ukw/podcast/fixed-income/delta-sub-zero-high-yield/


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At Hermes we are proud of the fact that we live and breathe liquidity. Our flexible-credit approach and embrace of the illiquidity premium – including the dynamic allocation between illiquid and liquid assets – are fundamental to the way we work.

But there is a limit to our flexibility: there are certain assets that we would just never include in certain funds and mandates.

We constantly refer to one of our investment mantras when constructing credit portfolios – understand the mandate.

So how are we positioned in these times? We believe there are opportunities for those capable of seeking them out. However, the nature of our approach means that we, for now, inhabit the most liquid parts of public-credit markets.

At this point it would have been nice to skip over the thorny topic of Brexit. Unfortunately, that is not possible under the current circumstances.

As a UK citizen, I am not personally proud of the mess that we have found ourselves in. Without commenting on our new Prime Minister, it is absolutely clear that the uncertainty that we (and the rest of the European Union) have been living through is coming to a head.

To date, Brexit-inspired currency-market volatility has not been fully mirrored in fixed-income markets. This may, in part, reflect the fact that credit investors have already priced in a Brexit premium.

Potentially, too, current holders of UK-domiciled assets or sterling-denominated securities are reluctant to sell their now riskier assets at a loss.

We recently observed that a few of the UK-based high-yield borrowers have sought cheaper funding in euro-denominated debt, including players in the structured-credit market.

Sterling-denominated issuance and collateralised loan obligations (CLOs) – where the UK makes up the largest borrower jurisdiction – represent a very large part of the European structured-credit market.

As the 31 October Brexit deadline looms, we will keep a close eye on all asset classes but the flurry of structured-credit issuances set for September marks this space, in particular, as a must-watch arena.

Prepare for attack

In closing, our top-down view is that most markets appear rather expensive (see figure 4). We also worry about the perception that ‘bad is good’ and the recent actions of central banks.

At a portfolio level, within the most liquid parts of our markets we think that cash assets look better value than synthetics (perhaps because shorts have been squeezed out).

We still see a meaningful illiquidity premium in some sub-asset classes, but issuance has slowed to a snail’s pace in many markets, making access problematic.

Finally, we still favour lending to the higher quality parts of all of the markets we invest in, with the aim of avoiding the upcoming defaults and low recoveries that we see on the horizon.

Sometimes the best form of attack is defence.

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Source: Hermes, JP Morgan, Bloomberg and Citi Velocity as at August 2019.

Figure 4. Movement in US dollar yields, year-to-date, as of Q2 2019


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But not all public-credit exposures tightened over the quarter. For example, spreads in the CCC-rated corporate sector widened by 150bps in Europe and 60bps in the US, reflecting the increased risk in low-quality debt at this point of the cycle.

Also, in the direct-lending sector, UK loans continue to be issued at a premium due to Brexit uncertainty: spreads on senior-secured loans widened by 25bps to 550bps, offering an approximate 125bps premium over other regions in northern Europe.

Relative value between asset classes

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Figure 5. Selected monthly spread data for the Q2 2019 period

Source: Hermes, JP Morgan, Bloomberg and Citi Velocity as at 30 June 2019.

Public-market credit spreads tightened to five-year lows in a move that bypassed the private debt and structured-credit markets, which increasingly demonstrate better value.Looking solely at headline figures, the June quarter seemed calm. Private-debt markets remained steady as public-credit spreads tightened slightly, but this apparent stillness in quarter-on-quarter results masked some volatility: public-credit markets widened until the end of May before rallying to near-record five-year tight levels by 30 June.

The late-quarter rally was likely due to some positive news on the US-China trade negotiations and indications of looser monetary policy settings in June.


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Figure 6 shows the Hermes Multi-Asset Credit relative-value framework as at the end of June 2019, highlighting the quarter-on-quarter changes in rankings. The data illustrates three major themes emerging in credit markets, namely:

�� The illiquidity premium available in certain areas of private-credit markets persists. The top-ranked direct-lending sector provides attractive relative value over public credit while commercial real-estate debt offers less of a premium. In particular, we like senior-secured direct lending for its attractive risk-adjusted returns. But we focus on higher credit quality within the broader direct lending market by looking for deals with good covenants in strong legal jurisdictions that support high recovery rates. Currently, we avoid lower parts of the capital structure such as unitranche and mezzanine loans.

�� The broad public-credit market looks less attractive, with investment-grade and high-yield spreads close to five-year tight levels, resulting in lower value scores across the exposures. Now, more than ever, credit investors need to identify areas of value in the market – and allocate with conviction – while reducing exposure to fully-priced sectors. We currently see good value in emerging markets and corporate hybrids – ranked second and fourth,

respectively. Within corporate investment-grade and high-yield markets, security selection is increasingly important. In general, we prefer cash bonds over credit default swaps (CDS) and longer maturities where credit curves are steeper and names still offer some convexity. At the same time, we avoid 13th-ranked CCC corporate debt, which has weighed down the broader high-yield segment.

�� Structured credit remains less affected by market sentiment, offering increasingly attractive relative values over equivalent-rated corporates: ABS and CLO spreads remain below the tight levels of public credit markets. Consequently, these assets provide attractive relative value both on a standalone yield and risk-adjusted basis, in addition to diversification benefits. Mezzanine CLOs moved up to third in the rankings, with BBB- and BB-rated securities looking particularly attractive for yield investors, but good manager selection is increasingly important given the loosening of underlying collateral documentation. Senior CLOs, ranked tenth, provide better defensive attributes than 12th-ranked senior ABS. Most ABS supply is currently in the UK, leaving investors exposed to Brexit risk. European equity CLO tranches, ranked 17th, continue to suffer from the reduced arbitrage of liabilities versus the underlying loan prices, despite a slowdown in issuance. Similarly, first-loss tranches and risk-transfer transactions also ranked lower this quarter, given weaker fundamentals.

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Figure 6. Our relative-value rankings as of Q2 2019


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Our relative-value scoring framework takes into account many factors, some of which we explore in depth below.

Figure 7 highlights both the spread and yields in US dollar terms as at the end of June for a selection of BB-rated credit exposures. The annualised yield, in addition to the credit spread, also takes into account swapping from local interest rates, price discounts, amortisation of any up-front fees and currency returns to dollar-denominated investors.

Plotting assets with the same credit ratings allows us to better compare investments on a like-for-like risk basis. Nonetheless, we acknowledge that credit rating is just one element of the many that determine underlying investment risk.

In theory, the yield on each asset should provide compensation for the various risks associated with each exposure, encompassing credit risk, currency, liquidity, scarcity or complexity and so on. However, in practice the risk assessment is more nuanced, which is why we consider 11 factors together – as per figure 6 – rather than ranking securities on each exposure individually.

For example, if we take the current dollar yields as a simplified indicator of the value generated by each exposure, there are two trends that help to explain the themes identified in our relative-value framework.

First, the private-credit exposures (outlined in orange in Figure 7) carry an illiquidity premium reflected by higher yields. Senior-secured private loans offer higher spreads than corporate bonds and leveraged loans.

Second, real-estate debt and private loans provide an additional yield pick-up over their spread versus corporates, partly due to upfront fees, which do not feature in public-credit yields.

It is important, too, that investors take into account the extra flexibility provided by liquid assets when assessing risk. We capture this by scoring each exposure according to a liquidity factor.

Based on these two opposite aspects of liquidity we can see why direct lending ranks higher in our framework than real-estate debt. In short, the higher yield on offer from direct lending more than compensates for the lack of liquidity among senior loans compared to real-estate debt.

Our relative-value chart also highlights the thematic effect of the ‘complexity premium’ across the credit spectrum. Less-mainstream instruments, such as subordinated financials or CLOs, can provide additional spread over traditional corporate bonds – and greater value for investors skilled enough to assess the risks buried in these more complex structures.

In our risk assessment framework, factors such as ‘loss given default’, liquidity and ‘alpha potential’ also help define the complexity premium implicit in each credit sector. For instance, combining these factors with attractive yields saw CLO mezzanine tranches rank highly in the June quarter due to their attractive value, on both an outright and a risk-adjusted basis.

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Figure 7. Spreads and US dollar yields for selected BB-rated credit exposures


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Q3 outlook: our scorecard

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�� The inverted US yield curve and slowing economic data signal that a recession is on the horizon�� US trade disputes with China and Europe are starting to impact earnings in affected sectors and could further slow global growth if not resolved�� Continued uncertainty about Brexit with the increasing risk of a no-deal outcome under Boris Johnson, the new UK Prime Minister�� Rising geopolitical tensions between the US, UK and Iran

Contents

9 Economic outlook Trade tensions have re-escalated and could bring an end to sustained economic growth

10 Credit fundamentals An excess of cheap money has created an upside-down world where markets ignore warning signs

11 ESG case study A hotel development in Soho, London shows how buildings can influence the environmental quality of places

12 Valuations and technicals Negative-yielding sovereign bonds are a drag on credit portfolios as higher demand compresses spreads

13 Public credit: relative value Mid-stream energy companies offer value to credit investors

14 Leveraged loans Global issuance of leveraged loans is subdued and has fallen to the lowest level since the end of 2015

15 Structured credit The ABS market makes a comeback as issuance soared in the second quarter

16 Private debt: relative value Yields on senior loans to European small-to-medium enterprises (SMEs) are steady, but lenders are competing to finance stable companies

17 Asset-based lending and real-estate debt Online shopping is hurting the retail sector and depressing yields on industrial properties


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Following a tentative resurgence in early 2019, the global economy weakened in Q2 with hard data and sentiment surveys signalling fatigue.

More worryingly, the recent decline in economic conditions predates the May 2019 escalation in US-China trade tensions, suggesting other forces are at play, including:

�� a strong US dollar;�� the impact from the Federal Reserve’s (Fed’s) tightening in 2018�� higher oil prices; and�� limited international spill-over benefits from the Chinese stimulus.

Regardless of the causes, the global composite Purchasing Managers Index (PMI) – a reliable indicator of economic trends – dipped to a three-year low of 51.2 this June. The PMI data primarily points to a manufacturing sector slowdown, synchronised across all major countries, although more open economies such as the eurozone and China suffered most. Negative sentiment also appears to be seeping into the services sector, which responds mostly to domestic demand.

After marking its longest economic expansion in Q2 (based on official records dating back to 1854), the front-running US economy appears to be coming back to the pack as its growth rates slow and converge with those of global peers.

Most economic data, and supportive monetary policy from the Fed, suggest that an imminent US slump is unlikely but recession risks are on the rise, based on signals including:

�� a sharp diversion between consumer and business confidence: the former, held up by strong employment, remains high while the latter – especially in the manufacturing sector – has fallen considerably (see figure 8);�� at the end of March, the US yield curve inverted as 10-year Treasury bill rates fell below the three-month rate. Based on this historically reliable gauge, the New York Fed judged the probability of a US recession in the next 12 months to be 30% – a high in the current cycle.

As usual, investors will keep a close eye on the US economy, which still wields the most powerful influence on global macro trends. The Fed slashed interest rates in July and the market has priced in a further 75bps of cuts before the end of the year. But the big question is whether even that will be enough to avert ‘hitting the wall’ as ongoing trade tensions and global political uncertainty sap economic energy.

The trade situation has remained volatile and an escalation of protectionist tensions – mainly concerning the US and China – is still the main downside risk for the global economic outlook. According to the OECD, if the US extends tariffs to cover 25% of all Chinese imports, global GDP would plummet by as much as 0.7% below current baseline levels in two to three years (see figure 9).

Clearly, a further intensification of US-China trade battle could be enough to break the global economy’s stride.

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Figure 8. The US manufacturing sector has weakened considerably

Tariffs extended to rest of US-China trade Tariffs plus higher global risk premia

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Figure 9. The OECD’s estimates of the impact from US-China trade tensions (impact on the level of GDP and trade by 2021-22, per cent difference from baseline)

Economic outlook

The global economy continued its marathon expansion in Q2. But the sugar fix of easy money may not be enough to sustain progress against the headwind of trade uncertainty.


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When global central banks serve as liquidity-pumpers-of-first-resort to the economic cycle – note that the current US expansion is now the longest on record – something perverse happens: bad news becomes good news.

In this upside-down environment, poor economic data – which normally signals weakening credit fundamentals – instead triggers a rally in spreads as investors expect central banks to douse the panic with liquidity.

Dovishness prevails among major central banks – the People’s Bank of China, the Bank of Japan, the European Central Bank, the Reserve Bank of Australia and, even now, the Fed.

Credit investors, it seems, have little to fear from monetary authorities. But what of fundamentals?

Global PMIs and sentiment surveys all indicate moderate contractions, even if they remain nominally in ‘positive’ territory. Year-on-year growth in US commercial and industrial lending is also slowing (see figure 10), which also threatens fundamentals. (We will continue to watch these metrics because tighter credit conditions in the US have surprised us, given the Fed’s dovish signalling since the beginning of 2019.)

Finally, we have also seen financial leverage rise moderately in certain parts of US debt markets, particularly in investment-grade credit.

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Figure 10. Easing off: US commercial and industrial lending

Nonetheless, we still believe that fundamentals and, importantly, company behaviour continue to support credit markets, especially at the higher-quality end of the ratings spectrum.

Financial leverage in investment-grade credit has, admittedly, climbed slightly over the year. But highly levered investment-grade corporates are generally using the conditions to their advantage, improving interest-rate coverage ratios by refinancing their debt at a lower cost.

For example, according to JP Morgan, from “year-end 2010 to year-end 2017 the average coupon of bonds in our High Grade Index (non-financials, ex-emerging markets) declined from 5.9% to 4.1%”1.

Furthermore, because the cost of refinancing debt should remain low (given the dovish policies among central banks), even if operating cash flow declines modestly, higher quality credit fundamentals will remain on a sound footing.

While a low-growth, low-inflation world is not ideal for high-yield investors, it gives no cause for panic either. Rather, the underlying conditions support our view that investors should not be hunting equity-like credit risk to boost performance: lower quality debt invariably requires stronger fundamentals to grow into capital structures.

Indeed, this scenario has played out in markets this year. JP Morgan again provides evidence: “Despite June’s rally, bonds trading sub-$70 increased $1.4bn m/m to a year-to-date high of $52.4bn (or 4.3% of the universe),” the bank states2. “While still down $6.6bn since December, the amount of distressed bonds [is] still comfortably above where they were at the end of 3Q ($20.6bn)… As such, the amount of bonds trading at distressed levels actually rose to a year-to-date high.”

The big three global credit-rating agencies may have forecast default levels to remain below trend into 2020, but we see no reason to chase yield up the risk curve in a late-cycle, politically fragile world.

Credit fundamentals

Monetary policies have created a negative-rate world in which markets rally on bad news and ignore fundamental warning signs.

1 ‘High grade credit fundamentals: 1Q19: a sector-by-sector review of trends in credit ratios’, published by JP Morgan as at June 2019.2 ‘Default Report’ published by JP Morgan as at June 2019.


11

Buildings influence the environmental quality of places, and their impacts can be positive – as shown by a hotel development in Soho, central London, that we have helped finance.The built environment accounts for almost 40% of carbon emissions3 – more than any other industrial sector. Given the environmental, social and financial benefits achieved through energy-efficiency improvements, waste reduction and recycling, lenders in this sector inevitably must pay attention to its environmental performance.

Property owners who put capital and energy into improving the environmental, social and governance (ESG) performance of their buildings already demonstrate the commitment to enduring quality that investors find appealing. But environmental improvements often increase the sustainability of the physical assets – and, therefore, of the income streams that flow from them.

We have seen plenty of real-world examples where stronger ESG performance creates a win-win for real-estate owners and debt investors, such as a new hotel development in Soho, central London, that we have loaned against.

The hotel replaced a building on the site, so the development did not result in the loss of any green land or plants. Overall, the land itself was of low environmental value but the developers engaged an ecologist to recommend how to improve the barren site by introducing native plants. After incorporating ‘green roofs’ and landscaping into the design, the hotel has a higher ecological value than the site’s previous incarnation.

The green roof provides many environmental advantages, including:

�� reintroducing plants and native species to the urban site; �� helping to reduce the ‘heat island’ effects found in central cities; and,�� improving the building’s thermal performance.

Energy efficiency was also a key focus, resulting in an ‘Excellent’ rating from BREEAM, a certification authority for sustainability in properties. In addition to the green roof, the building is well-insulated and achieves high overall thermal performance. Combined heat and power units generate both heating and electricity for the building. Meanwhile, highly efficient air-source heat pumps either warm or cool the hotel as needed.

The hotel also generates, and uses, its own power from an array of photovoltaic panels on the roof while lowering electricity consumption with LED lights installed as standard throughout.

Minimising water usage was another objective. Monitors have been installed to detect leaks and provide alerts about excessive consumption. The native plants in the rooftop garden also require little irrigation once established.

ESG performance is also a feature of the hotel operations, where rigorous staff training about recycling protocols ensure no waste is sent to landfill. The hotel composts food waste on-site while Westminster Council collects recyclables. Even recycling costs are minimised, as glass-crushing machines save space and reduce collections to twice a week, compared to the usual daily run at most hotels, helping to reduce vehicle emissions and congestion in central London.

The hotel’s close proximity to public transport connections such as tube, bus and train stations – including a stop on the Elizabeth line, which is under construction – plus a cycle-friendly staff policy and on-site bike storage facilities, further helps reduce emissions.

ESG case study

3 International Energy Agency as at August 2019.


12

Valuations and technicals

Sentiment

However, the growing stock of negative-yielding sovereign bonds – hitting about $9.4tn at the end of June, according to JP Morgan – will remain a drag on credit portfolios with higher demand compressing spreads.

Morgan Stanley Global Risk Demand Index

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Figure 11. Investor sentiment rose with dovish central banks in Q2

Asset flows

Net supply became positive during the quarter for the first time since start of 2018, as the weak equity market encouraged issuers to tap the bond market instead for financing – particularly in the high-yield sector. The increase in supply was easily digested, aided by strong inflows into the asset class.

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Figure 12. Increasing issuance was met by greater flows in Q2

Credit demand was restrained during Q2 as interest-rate volatility breached multi-year highs. With the market expecting a normalisation of rates volatility over the next few months given renewed dovishness among central banks, inflows into credit could resume.

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Figure 13. Interest-rate volatility reaches its highest level since 2016

Investor confidence was buoyed in Q2 as dovish tones from global central bank chiefs chimed with supportive tweets from the Osaka G20 meeting late in the quarter.


13

Lower-quality energy companies that are dependent on higher oil prices to break even are struggling the most.

But we are still finding value in the energy sector through corporate hybrids of utility-like, mid-stream companies – such as those specialising in the storage or transport of oil. Mid-stream energy firms tend to earn income based on long-term contracts, which largely insulate them from commodity-price swings.

Mid-stream energy company hybrids can offer exposure to the quality end of the high-yield spectrum. The recent increase in spreads between unsecured bonds and hybrids, sparked by an oil sell-off earlier in the year, also illustrates the opportunities available to investors who know the subtleties of energy-sector credit.

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Figure 14. Surging: energy-sector credit spreads

Convexity in the high-yield market worsened during the quarter as stable fundamentals and a supportive technical backdrop spurred stronger performance. The conditions suggest that high-yield investors increasingly need to allocate capital away from securities demonstrating negative convexity, such as callable bonds.

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Figure 15. Yield to maturity (YTM) minus yield to worst (YTW) in global high yield

Corporate bonds rated CCC continued to underperform their expected beta this quarter but remain far from cheap in comparison to B-rated instruments. Despite ongoing spread tightening in the high-yield market, we think investors should remain wary of lending money to issuers that will struggle in a weaker economic environment.

1.701.801.902.002.102.202.302.402.502.602.70

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Figure 16. CCC-rated instruments remain expensive

Public credit: relative value

In the year-to-date, the US energy sector has underperformed the broader high-yield benchmark by more than 150bps. High-yield energy debt is now cheaper compared to the sector average by almost two standard deviations.


14

Year-on-year global loan volume in Q2 declined by more than 23% as issuance sunk to $128.7bn, compared to $166.9bn in Q2 2018. By contrast, the average quarterly loan volume from January 2016 to Q1 this year sat at $172bn.

The slowdown witnessed since the January 2019 quarter has weakened both European and US loan issuance, with the latter market sinking to $233bn in H1 this year compared to $380bn for the first six months of last year – a fall of 40%. Over the same period, leveraged-loan issuance in Europe declined further, dropping 45% to $42bn from $75bn.

However, the CLO market is booming, with $39bn printed in the second quarter of 2019 alone. By mid-June, new CLO issuance in Europe hit €13.5bn, making it the largest half-year result since 2010. CLO issuance in the first half of this year exceeded full-year figures reported in 2013 (€7.4bn) and 2015 (€13.8bn).

The high demand for loans had two major consequences: first, reported loan-flow composite figures in the US and Europe increased by 57bps and 66bps respectively in Q2, supporting the secondary market, according to research house LCD; and second, an increase in cov-lite deals: 95% of new institutional debt consisted of cov-lite instruments in H1 2019, compared to 88% last year.

According to LCD, reported loan-flow composite figures in the US and Europe increased by 57bps and 66bps respectively in Q2, supporting the secondary market.

Average European new-issue, institutional, term loan B spreads increased from 381bps to 392bp over the first half of 2019, despite a decline in total leverage (rolling average three-month total leverage was 5.51x at the end of December 2018 compared with 5.31x at the end of June 2019). The rise in secondary pricing – and therefore the reduction in the discount to par – coupled with the increases in spread, made the total yield for European leveraged loans reasonably stable over the first half of the year at 4.12%, but still down from 4.35% last year. Consequently, we think the increase in cov-lite deals and the weaker documentation is not fully priced into primary-loan issuance, in the form of either a wider spread or larger discount in price.

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Figure 17. Global new issuance of loans remains subdued

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Figure 18. Average bid prices for US and European loans

Leveraged loans

Global leveraged-loan issuance is on the wane, slumping to its weakest quarter since the final quarter of 2015.


15

The ABS market was enlivened in Q2 as commercial mortgage-backed securities (CMBS) issuance ended the previous quarter’s silence, with about €2bn of CMBS paper being issued in H1 – on par with the first half of last year.

An increasing number of deals referenced the Sterling Overnight Index Average (SONIA) benchmark, suggesting issuers are preparing for the end-of-2021 deadline to have transitioned away from the London Inter-Bank Offered Rate (LIBOR) as a benchmark.

The number of fund managers in the European CLO market has grown to about 50. Many of the new entrants are global firms with strong US track records looking to diversify into Europe.

But the shift into Europe has not been painless for some: according to media reports, this year two managers scuttled their first European deals before leaving the warehouse.

Arbitrage – or the difference between the cost of liabilities and underlying assets – has been the main problem for CLO managers in 2019, resulting in fewer transactions in warehouse phase compared to last year.

The European CLO world faced further structural challenges in 2019 as Japanese banks, the long-time anchor AAA-tranche investors, eased purchases following regulatory scrutiny at home.

Despite the changing market backdrop, CLO demand in Europe was sustained by a more diversified investor base, which saw deals printed in line with what could be expected if Japanese investors continued to buy at previous levels.

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Structured securities

The June quarter saw an asset-backed comeback as issuance in the European primary market surged after a supply-constrained start to the year.


16

Private debt

Lenders are increasingly seeking shelter in higher-quality credit as Brexit, trade wars and volatile stock markets buffet the global economy.

Although yields on senior loans to European SMEs have remained steady – even increasing slightly in some jurisdictions – lenders are competing fiercely to finance well-managed, stable companies operating in non-cyclical industries.

Consequently, some direct lenders have struck extremely aggressive deals lately, easing both leverage and loan terms in bids to win business. But we still see senior-secured loans to SMEs, which feature strong equity buffers, as offering the best risk-reward trade-off in the market.

With enterprise values at all-time highs, we favour deals with low loan-to-valuation metrics as a shield against any future downturn. It follows that we prefer conservative loan structures and terms rather than cede loan-protection rights in exchange for a small uptick in yield. This is the prime advantage of SME lending over large-cap syndicated deals.

European senior-secured SME yields have remained relatively stable. But increased competition has resulted in some tightening of yields across France and Italy, further denting the case for investing in such debtor-friendly regions.

However, some UK loans – particularly in non-cyclical industries – offer good value. The UK lending market offers a sterling premium of approximately 100bps over the European market, coupled with a positive legal environment for investors.

Scandinavia remains the most attractive European region, providing strong yields underpinned by stable economies and supportive laws. Investors face the challenge, though, of accessing loans in these banking-led markets.

Elsewhere, value persists in the smaller mid-cap sectors of Germany and the Benelux countries, despite rising competition in these regions.

Loan protections continue to be flattened under the weight of money flowing into the mid-cap direct-lending market, making selectivity and access crucial for those aiming to invest prudently.

Private lending


17

UK real-estate debt is still keenly priced. Prime-office and industrial-stock margins currently hover about 150-200bps above LIBOR for 50%-60% loan-to-value deals, despite slowing capital growth in the underlying real-estate market.

In total, UK commercial property returned 0.4% in the first quarter of 2019, but the result masks a wide disparity in sector performance: the industrial and office markets were up 1.7% and 1.1%, respectively, during the three-month period while retail fell into the red by -1.3%.

The retail sector suffered from rising vacancies and falling demand for space as online sales encroach ever-more on consumer spending habits, forcing an increasing number of shop-front retailers to close their doors.

Rental property prices and yields likely have further to go before the sector appeals again to investors. However, there are still niche lending opportunities as owners reposition assets in prime locations through, for example, partial conversions into residential or office spaces. As a rule, retail properties located in affluent areas – either in stand-alone units or shopping centres – should outperform the broader sector.

Another side effect of the online-sales phenomenon is that it has transformed industrial property from a traditionally high-income, low-growth exposure into the lowest-yielding sector. Over the last five years, industrial property has experienced significant growth, driven in part by demand for warehousing facilities for online retailers, resulting in the sector being priced above the retail and office markets (see figure 20).

This document is published solely for information purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Past performance is not a reliable indicator of future results.

Industrial property should continue to outperform given the strong demand for both equity and debt investments in the sector.

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Figure 20. UK real-estate yields

Asset-based lending and real-estate debt

Underneath positive overall performance by the UK commercial-property market, the onslaught of online shopping is damaging the retail sector and driving down yield on industrial properties.

For professional investors only. The views and opinions contained herein are those of Andrew Jackson, Head of Fixed Income, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable, but Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. Figures, unless otherwise indicated, are sourced from Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.

Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Sixth Floor, 150 Cheapside, London EC2V 6ET. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”). BD03369 00006804 07/19

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