Standard Life Investments

Focused Insight

Credit - stick to the fundamentals

  • A world of low yields poses a challenge for credit investors
  • Why an unconstrained approach offers the potential for capturing a compelling return
  • Why fundamental, bottom-up credit analysis is key

In a world in which some 50% of investment grade-rated bonds are trading with a yield of less than 1%, generating a compelling return from credit is a challenge. Even with the recent increase that has followed the US presidential election, yields and credit market returns remain low, posing challenges for client-specific outcomes around growth and income. This backdrop has forced many investors further and wider in terms of the yield curve and credit markets. The result has been that many investors have assumed greater levels of risk in an already volatile environment.

In our view, this difficult backdrop of low rates and heightened volatility is best overcome by pursuing an unconstrained approach to credit selection, within a framework that can measure and manage portfolio risk appropriately. This opens up a much wider opportunity set across sectors, geographies and credit ratings, but more importantly allows us to take exposure to those issuers in whom we have the highest conviction from a fundamental and value perspective. However, before forming a conviction view of an issuer, careful assessment of idiosyncratic credit risk and whether you are being paid for taking on that risk is required. Fundamental, bottom-up credit analysis is essential; successful credit selection is central to long-term outperformance. Get this right and the global credit universe continues to offer a diverse range of opportunities.

Property company China Overseas is an example of this. The company is majority state-owned and has the strongest balance sheet in the Chinese property sector. It also boasts good cash flow and a long-term management team battle-hardened by numerous property cycles. This in itself would be enough to make China Overseas a solid credit, but it has also been bolstered by the easing of property restrictions in China, which has helped house inventories and prices recover. This strong fundamental profile, combined with increased demand for the long-dated dollar debt of Chinese companies due to reduced issuance, has resulted in the impressive performance of the China Overseas 2043 US dollar bond.

However, maintaining a focus on fundamentals is also vital to avoid downside risk. In Europe, for example, quantitative easing has distorted valuations in certain parts of the market. The advent of the Corporate Sector Purchase Programme (CSPP) prompted a strong rally in those issuers deemed eligible for purchase by the European Central Bank (ECB). But when purchasing these issuers, paying due attention to their underlying fundamentals is important.

As an eligible issuer, K+S Kali, the German potash manufacturer, saw its spreads tighten sharply in the run up to, and immediate aftermath of, the launch of the CSPP in June. This rally ignored the company's stretched balance sheet and the weak outlook for potash, its key commodity. When Standard & Poor's put the company on negative rating watch, the spread on its 3% 2022 bond climbed by around 100 basis points as investors realised a downgrade to high yield would render it ineligible for purchase by a price-insensitive buyer, the ECB. Clearly, a positive technical backdrop cannot solve the problems of issuers facing fundamental difficulties.

As a world of low numbers – growth, inflation and yields – challenges investment returns, portfolio managers will have to fully leverage their expertise in order to achieve an attractive return from credit, rather than rely solely on market returns. However, the backdrop remains broadly supportive, if not without a number of economic, political and technical risks. With an unconstrained approach, exposure to a wide array of opportunities across a diverse range of sectors, regions and credit ratings can benefit both performance and volatility management. But to do this successfully, understanding exactly what you are investing in and why remains key.