Should bond investors prepare for summertime blues?

June 14, 2017

Phil Milburn,  co-manager of the Kames High Yield Bond fund, considers whether the bond market will wobble in the summer months.

Summer is traditionally a time when bonds - and indeed most markets - can be impacted by seasonal sell-offs, with lower trading volumes exacerbating swings in prices.

The holiday season has historically tended to witness a small market wobble, and indeed with valuations elevated across parts of the fixed income market, we believe there may well be better opportunities to invest fully at a later date.

Some parts of the fixed income market look more vulnerable than others currently. Default risk across the high yield market is set to remain on the agenda following the events in the US energy sector and the spread premium present in the market because of this.

Part of the 2015/16 increase in defaults was due to the deterioration in the price of oil, with earnings badly hit in the energy sector during the commodities crisis. However, the market has done a good job of purging itself of those problem credits.

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In fact, despite ongoing concerns about some areas of that segment of the market, I am relatively sanguine about the endogenous outlook for developed world high yield when it comes to default rates.

There will always be pinch points and these include retailing in many parts of the world, as well as other sectors strongly impacted by technological evolution. However, these areas are now small enough as a percentage of the market to be treated as idiosyncratic risk, rather than a systemic problem.

Currency mismatch

My main area of concern, and one that we are therefore positioning to avoid, remains emerging market high yield corporate debt. For some time there has been a big currency mismatch between debt issued in hard currency and local earnings. However, even here, I doubt there will be too much contagion.

The biggest shocks will therefore be exogenous in nature and would impact more on the price of risk than affecting the risk itself. Looking at high yield debt markets in particular, they are supported by both strong economic growth and near record low interest rates, meaning companies can cope comfortably with their debt burdens. Obviously if interest rates skyrocketed then this thesis would change, but consumers and sovereigns would also fail to service their debts in such an environment.

As it stands we remain in a period of financial repression with some late cycle attributes, such as higher corporate leverage. This could spook some investors, but authorities have invested so much in sustaining the economic cycle that we believe the main threat - namely a rapid rise in rates - is almost inconceivable.

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