Global credit: Hedging bets on the recovery

We expect the remainder of 2021 will be challenging, but in a different sense than 2020 given the high valuations at the start of this year. Returns will be harder to come by but should still be positive. We think corporate bond spreads are probably near their tightest but could become even tighter through the balance of 2021 as global growth recovers exponentially. Spreads will widen eventually, given the unprecedented governmental fiscal spending and the increased easing of pandemic restrictions.

However, in the near term, investment grade bond spreads could see another 20 basis points of tightening, closing in on the tight pre-2008 levels (see Chart 9), and below-investment grade bond spreads could tighten by 50 to 100 basis points (see Chart 10). Where there are opportunities to pick up some incremental yield in corporate credit, we think this positioning will be well compensated over the next 12 months. Overall, we are constructive on corporate credit, especially the shorter end of the curve. Pro-cyclical sectors, such as commodities, basic materials, and healthcare technology provide interesting opportunities.

However, we believe active management will be key in these conditions, as the opportunities across corporate credit markets will be selective and uneven. Investors will need to use all the tools in their toolkits, including sector, duration, and quality rotation. While continuous monitoring of the macroeconomic environment will be important, so will strong underwriting criteria for individual securities given the nuances and small anomalies across the corporate bond spectrum.

Security selection will be particularly important within high yield, where we currently see a bifurcated market. For example, within the CCC component of the US High Yield Index, more than half of the securities in this segment yield 6.5 per cent or lower while roughly 14 per cent of the constituents yield 9.5 per cent or higher as of May 31, 2021.

With investors increasingly concerned about the potential for a spike in inflation, the first quarter offered a preview of what could happen. Treasury yields rose by approximately 75 basis points, jarring asset prices significantly during the quarter. If inflation returns for real – and assuming it is the result of stronger economic growth—longer-duration assets will be repriced across the quality spectrum. In this scenario, we would expect more equity-like assets, namely lower-quality assets with shorter maturities and pricing power, to outperform other fixed income segments. The rate curve should initially steepen before the market prices in a policy response from the central bankers.

While we see opportunities from the global economic recovery, we also are seeking to insulate portfolios from a potential uptick in inflation. Currently, our sector rotation is geared toward commodities and basic materials with the intent of capitalising on those sectors poised to benefit from the post-pandemic economic reopening. On the inflation front, we also are focused on those entities that have pricing power as a potential hedge against rising prices.

To help cushion portfolios from potential spikes in interest rates, we are tilted toward securities with shorter maturities or with expectations that the bonds will be called. However, given the speed of the recovery and resulting pressure on central banks to change policies, this positioning may be outdated by as early as mid-way through the third quarter; that is where flexible guidelines and active rotation will come into play. We will assess the global macroeconomic landscape continuously and reposition accordingly as conditions evolve.

Brian Kloss is a portfolio manager for the Legg Mason Brandywine Global Income Optimiser Fund, part of Franklin Templeton