Now’s the time to reduce risk across the board, especially in developed markets outside the US, PineBridge Investments’ Steven has said.
Oh, who is global head of credit and fixed income at the asset manager, said the current credit cycle hasn’t completely died in his latest commentary.
‘The current cycle has become elongated, with the European sovereign debt crisis and the recent commodity collapse as two recent examples of relatively short-lived “mini-cycle” sell-offs from which the market bounced back reasonably quickly.’
He added that market excesses are currently limited. However, if the risk appetite continues to rise, a more volatile market downturn can occur.
‘This implies that investors may eventually be rewarded for paring back the riskiest segments that generally have outperformed within and across developed market credit over the past few years, and suggests they should be more selective in evaluating risk-adjusted return potential.’
Where to cut
Investment grade investors might need to decrease BBB allocations towards more cyclical sectors, Oh said, with allocations moving towards relative yield opportunities in CLOs, for example.
‘Historically, CLO tranches rated single-A or higher have suffered no loss of principal when held to maturity. European and Asian credits hedged for FX risk also offer incremental excess return opportunities,’ Oh added.
Oh and his team continue to favour floating-rate secured loans over high yield bonds. However, he said investors should consider decreasing the highest risk CCC-rated allocations and second-lien exposures.
‘In Europe, loans currently offer a yield advantage over the US when adjusted for FX, but higher tail risks from the Italian budget and Brexit scenarios call for maintaining a close to neutral stance,’ he added.
Supply/demand mismatches in the US
Oh said investors should anticipate a less attractive technical backdrop in the US next year, as the country’s expanding budget deficit is set to increase $1 trillion by 2020. This means the US will need to increase debt issuance substantially, Oh said.
‘The potential imbalance in supply/demand conditions could place upward pressure on yields in an environment of weakening economic conditions that is typically beneficial for bond investors,’ he added.
Oh said rising FX costs have chipped away at the net yield advantage in treasuries and European.
This is while Japanese yields have started looking more attractive to local investors relative to the US debt, lowering global demand for treasuries at the time when supply will be increasing.
Oh added: ‘At current levels, we prefer US Treasuries over other developed-market sovereign bonds, but we would advocate a relatively short duration profile and seek to preserve capital within the safe-haven component.’