Invesco Global Investment Grade Corporate Bond Strategy Insights

The final quarter of the year was marked by the announcement of three Covid-19 vaccines and the expectation of a roll out in 2021 which fuelled hopes for a medium-term global economic recovery.

The end might be in sight, but the present reality is still challenging as infection rates continue to rise and the emergence of a new variant rattled the markets by year end.

This led to full lockdowns across several countries in Europe including the UK; the respective central banks responded with additional support.

Lastly, a Brexit deal was finally reached after many rounds of negotiations and just before the end of the agreed transition period on the 31^st of December.

The removal of this very real tail risk event was a material positive for risk markets.

2020 Summary

The strategy was well positioned going into the pandemic induced volatility, with a more conservative stance primarily due to tighter valuations and several tail risk events not fully resolved in our opinion (Brexit, US-China trade and also the US Presidential Election). Of course, we did not envisage the pandemic.

During the third week of March, the US Federal Reserve (Fed) announced it would begin purchasing corporate bonds for the first time. This led to US credit aggressively outperforming which, due to our underweight, impacted the strategy’s relative performance through to mid-July. This positioning did, however, help mitigate the negative ratings agency action as we saw US companies bear the brunt of these by a ratio of about 3:1 versus Europe.

From mid-July into year-end the strategy performed strongly, recouping all the underperformance versus the benchmark to finish ahead for the year. This was primarily driven by the strong performance of European Credit (which we are overweight due to our Credit Cycle Differentiation Theme) as the European Central Bank remained hugely supportive whilst the region also announced a fiscal response to the pandemic via the European Recovery Fund. This helped to reduce fragmentation risk in the region.

The positive sentiment in Europe also resulted in the higher beta parts of the market outperforming. Here, the strategy has a preference for the corporate hybrids and subordinated financial bonds of high-quality investment grade rated European companies. These further enhanced returns over the period as they continued to play catch up to the broader market rally whilst generating additional carry.

Strategy and Outlook

The positive vaccine developments have helped drive valuations higher across most risk assets, with investment grade corporate bonds no exception. Whilst it is clear much of the broad-based rally is behind us, we still consider there to be a lot of value in investment grade corporate bonds given the level of dispersion from a regional perspective, as well as from a capital structure perspective. This, combined with the high quality carry nature of investment grade corporate bonds, lead us to have a positive view on the asset class as we move into the new year.

This is underpinned by our macroeconomic financial repression/secular stagnation view. That is, low growth and low inflation combined with extremely accommodative monetary policy is here to stay. Indeed, whilst a rebound in global growth is our base case for 2021 through the easing of lockdown restrictions in the second half of the year, a return to pre-pandemic GDP levels is not anticipated until at least 2022 across North America and Europe. Therefore, we remain convicted that financial repression/secular stagnation will continue to be supportive of high-quality spread assets for the foreseeable future.

Seeking value in this environment is well suited to our relative value approach to corporate bond investing, whereby the Investment Themes (See Fig.1) drive positioning versus key Thematic Risk Factors. The risk factors are defined as Sectors, Regions, Capital Structure, Credit Curve Term Structure and Currency of Denomination. For 2021, we believe the biggest opportunities exist on a regional and capital structure basis.

Regionally, we retain our preference for European corporates versus the US driven by the Credit Cycle Differentiation Theme. In Europe, balance-sheet preservation trends remain positive whilst corporate balance sheets were broadly in better shape as we entered the pandemic. We believe that Europe is now firmly in an early credit cycle phase, where the focus of CFO activity will continue to be on reducing costs, increasing cashflow and reducing leverage rather than focusing on shareholder friendly activity; hence the mid-term corporate fundamental picture remains reasonable in our opinion.

With the US leading the initial stage of the recovery due to more aggressive monetary and fiscal responses compared to other regions (this created extremely strong technicals supporting the region), we believe that the next stage of the recovery will be more fundamental and valuations driven, which will be supportive of European corporates given the greater dispersion in opportunities within the region and across the capital structure.

That said, we also expect technicals to remain positive across European credit markets through 2021. The ECB is anticipated to buy up to €10 billion of corporate bonds per month, equating to approximately 1% of the eligible index, which at this pace they will end up owning close to 30% of all eligible debt at the end of the scheduled programme. Given this global Central Bank backstop, we believe that the risk of spreads materially re-widening remains low.

In addition to Europe, we view the opportunity in Asia as even more compelling, given more attractive valuations. Fundamentally, this is driven by our First In First Out (FIFO) pandemic thesis coupled with their historical experience of managing pandemics in the region, which should lead to both a greater and more sustained recovery.

In fact, we expect that 50% of next year’s global growth estimate (mid 5%) to be driven by Asia. We have already begun to see this trend emerge in 2020, as evidenced by higher mobility rates across Asia versus the rest of the world. In addition, we continue to see strong evidence supporting our China Rebalancing Theme. Here, we expect that China will successfully transition into a consumption led service economy from one that has relied on foreign direct investments and low-cost manufacturing.

The resultant rise in consumerism from a growing middle class, urbanisation and significant ecommerce trends will see a stable growth picture and a growth outlook focused on quality rather than quantity. This consumption upgrade has already seen the composition of Chinese growth move from manufacturing, agriculture and construction to being more driven by services in the last few years, and we expect this trend to continue.

We therefore see good opportunities to invest in Chinese corporates via offshore markets (USD and EUR denominated), which on a rating and duration adjusted basis trade with an attractive yield premium to their US and European counterparts.

Within this universe we focus on sectors and names that will benefit from this consumption story i.e. the technology giants (Tencent, Baidu and Alibaba), as well as key State-owned corporates with strong strategic importance to China in implementing their long terms plans and policies (Made in China 2025 or One Belt One Road initiatives).

Our conviction in this trade has increased during the pandemic due to Asia’s effective control of the virus, resulting in less restrictions versus Western countries, hence the FIFO thesis.

In terms of capital structure, we continue to identify attractive opportunities in subordinated instruments across both financial and non-financial issuers, which help to increase the yield and carry profile of the strategy.

This is driven by two themes, the first being the Financial Deleveraging Theme. Here, we continue to witness banks becoming more utility like post the Global Financial Crisis due to increased regulation, resulting in capital levels that are materially higher today. The Covid-19 pandemic created an economic/liquidity crisis for corporates following government lockdown measures designed to slow the spread of the virus - this is not a banking crisis.

The second theme driving our preference for subordinated bonds is the Japanification of Europe which is predicated on our secular stagnation view (low growth, low inflation and easy financial conditions) and that ultimately Europe will become like Japan due to (the 3 D’s):

Demographics; Europe’s ageing demographics increase the number of savers versus spenders (capping growth)

Disruption; whilst digital disruptions should help to keep inflation in check

Debt; meanwhile, elevated levels of government debt require the ECB to keep policy easy to facilitate well-functioning capital markets

This low growth and low inflation with easy financial conditions environment is very conducive for high quality corporates and taken together with well capitalised banks, reduces the probability of default in the region. Hence, we can feel comfortable to invest down the capital structure in names we like.

In summary, whilst global investment grade corporate index level valuations have recovered since the onset of the global pandemic, dispersion and differentiation within the asset class still offers attractive opportunities to capture returns.

This also helps to ensure the strategy continues to offer a significant yield carry over the index, which in this low yield environment we believe will contribute meaningfully to overall returns through 2021.