The value of sovereign debt with yields below zero increased to over 8 trillion US dollars last year, pushing some fund managers to shift into lower quality bonds in the hunt for yield. Others, restricted by mandate to high quality borrowers, have dipped into longer-dated bonds. Last year, the latter strategy has paid off: government debt maturing in more than 10 years time returned 12.2% last year, according to Bloomberg, beating the performance of stock markets in the US, Europe and Asia.
In an exclusive interview, Tatjana Greil-Castro, portfolio manager at Muzinich & Co speaks to Giada Vercelli about her expectations for the year ahead.
Tatjana Greil-Castro: Central bank policies have been very accommodative over the past few years, with the ECB having been the last central bank to start a QE programme. These policies have meant that duration has been investors friend during these low inflation and accommodative central bank policy years. However, it appears that growth has generally been picking up during the latter half of 2016 and is expected to run at a decent rate during 2017. With these improved growth expectations and a decline in unemployment, there is an expectation that inflation should also move somewhat higher, which in turn would suggest that central banks should start tapering in the case of the Eurozone and raise rates further in the case of the US. We, therefore, are cautious with regards to duration for 2017. Many investors appear to be agreeing with our view as we witness large flows out of longer duration strategies into lower duration strategies.
Giada Vercelli: The duration on the Barclays global aggregate bond index hit a record high last quarter. What is to be expected, though, if the Federal Reserve raises interest rates more aggressively this year? Normally, lower rates mean longer duration...
Tatjana Greil-Castro: Companies have been taking advantage of the favourable funding rate at which they could borrow money for the long term. And as long as investors felt that central banks remain accommodative and a large part of the fixed income market yielded negative or very little, they were willing to go out the curve. More recently, new issues are funding with shorter tenors again as investors have lost their appetite for long dated paper.
Giada Vercelli: Governments have been among the chief beneficiaries of long duration: the US Treasury in primis have enjoyed strong demand for 10-year bond auctions. Is there now a concern for the buyers of the longer-dated bonds that yields will jump higher?
Tatjana Greil-Castro: Judging by the fund flow data we are following, we are observing investors reducing their duration exposure.
Giada Vercelli: The path to higher rates in the US has kept investors on their toes as to how fast the Federal Reserve will add to the rate rise. What are your expectations for factors which could trigger a change in policy such as inflation and wage pressures, and how do you play those?
Tatjana Greil-Castro: We believe that the Fed is getting ready to raise rates at a moderate pace in 2017 and onwards, should the currently anticipated growth rate materialise. Inflation in the US has reached close to the 2.0% inflation target by the Fed and any protectionist measures by the new administration could lead to further price increases.
Giada Vercelli: How have these dynamics been affected by Brexit?
Tatjana Greil-Castro: In my view, Brexit and the new Trump administration are the symptom of the same underlying dynamic that has left a large part of the population feeling alienated and unheard by the established political system and their view of the world.
Giada Vercelli: The impact of the central bank stimulus has also lifted demand for corporate bonds, as investors are forced into the riskier corners of that market. Last year US retail giant Target and Chinese oil company, Sinopec, sold 30-year bonds. How should the market deal with the lack of new issuance and the related slowdown in M&A activity?
Tatjana Greil-Castro: We have already experienced a slowdown in new issuance in the high yield markets, with only the European investment grade market having grown significantly during 2016 as companies are taking advantage of the ECB bid. Investment grade companies in the US have re-levered over the past few years in order to fund share buy-backs and dividends but as their earnings recovered, there has been less pressure by shareholders for further increases in leverage. We have also noticed that issuers are printing shorter dated deals again as the appetite for longer dated paper has diminished, as discussed earlier. It is however correct that investment grade indices increased duration over the past few years as they printed longer dated paper and coupons became smaller.
Giada Vercelli: Companies may use the funds to buy back shares rather than invest in capital projects or pay for research and development. This is hardly healthy for investors. What are your thoughts on this?
Tatjana Greil-Castro: We have noticed a strong share buy-back and dividend behaviour predominantly by US investment grade companies. However, this behaviour seems to have peaked about a year ago. Moreover, the companies which engage in that behaviour are generally high cash-flow generating entities that could afford a higher debt burden.
Giada Vercelli: Nevertheless, investors appetite for the bonds remains, despite a string of downgrades, yet the talent to adequately forecast a companys or even countrys ability to pay a bond in 30 years is dubious. How do you fine-tune this ability at Muzinich & Co?
Tatjana Greil-Castro: We generally prefer to take credit risk over duration risk as we feel that we have a strong expertise in analysing companies credit profile. Therefore, we rarely invest in very long dated bonds. This investment philosophy has kept us in good stead over the years, as evidenced by the risk reward profiles of our strategies.
Giada Vercelli: Earnings vs incorporation place is an increasingly important factor in defining where fundamental risk lies. How do you play this level of analysis?
Tatjana Greil-Castro: We have a large and very experienced team of credit analysts who are sector specialists and generally build a strong rapport with the companies we invest in. We use propriety models which help us assess the companies credit profile with a strong focus on the companies ability to generate cash.
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