Credit history bodes well for returns

Credit markets offer investors healthy returns, despite the uncertain trajectory of the economy, especially if the positive pattern of results of American high yield stand-out years is repeated.

Possible extreme events include sovereign risk. Banks have huge problems that are not going to be solved through un-stressful stress tests and new regulation. They need to rebuild their capital bases, deleverage their balance sheets, decouple their investment banking activities from the core and increase their lending to small and medium enterprises.

”If this were to repeat itself in 2010, high yield returns of about 8-10% would be likely”

Finally, corporates are increasingly relying on the credit markets for liquidity and banks will be issuing up to $1 trillion (£640 billion) of paper over the next three years as they rebuild their balance sheets. There might come a point when that supply swamps the market, particularly when investors fear rates are about to be raised. The effect could be a higher cost of capital over a short time – causing losses for fixed income investors.

If this base case forecast is correct, how should credit investors be positioned? Investors should focus on shorter maturities and seniority within capital structures. Companies with strong liquidity positions and non-cyclical businesses that can withstand a significant slowdown to their top line look particularly attractive. Yields of about 7-8% can be found for such opportunities in today’s market on an unleveraged basis.

With the regulatory outlook uncertain, investors should focus on the non-bank financials where debt prices have been marked down by association with banks. As the picture in the banking sector clears over the next couple of years, there will be many opportunities in financials to generate high risk-adjusted returns.

Even in tough economic conditions, some companies will thrive. These are businesses that suddenly experience a surge in demand, margins improve and deleveraging can occur. Also, many strong businesses in the “non-developed” world continue to trade at attractive levels compared with similar businesses in America or Europe. As the world continues to rebalance, these situations will be arbitraged out.