Darker corners of debt markets offer refuge to investors

Federal Reserve chair Jerome Powell. Photo / AP

COMMENT:

A vast policy response from governments and central banks has averted the worst of the financial pain from the Covid-19 crisis, leaving investors to gauge the long-term costs and opportunities.

Asset prices have rebounded but deep concerns remain about financial instability. A legacy of a heavily indebted financial system weighs on growth prospects.

But even then, patient investors may find long-term opportunities in a wave of corporate defaults and restructurings, with some already active in this area.

In part, that is because the outlook for equities is glum. The latest monthly survey of global fund managers by Bank of America revealed 67 per cent expect an annualised global equity return of 3.4 per cent over the next 10 years. Corporate earnings face pressure from structural shifts such as supply chain reshoring, protectionism and higher taxation, all of which should increase costs.

Equity valuations will also lack what has been a significant driver of price appreciation in recent years: falling long-dated government bond yields.

Unless yields can sink much further — unlikely given policymakers' aversion to negative interest rates — there is little more they can do to flatter the returns available from stocks.

That is not the only complication stemming from the bond markets. With key 10-year benchmark yields camped around zero, a diversified portfolio split into stocks and bonds has less ballast. The fear is that bonds, at these elevated prices, are incapable of absorbing shocks as well as they once did. Given that, chasing riskier bets in equities is a less appealing prospect.

Much rests on what kind of economic and earnings recovery arrives after the pandemic and whether massive stimulus packages can offset the damage inflicted by shutdowns. Central bankers are clearly worried about long-term damage and the latest monetary policy report from the Federal Reserve lays out the challenge facing an important engine of job creation in the US economy: small businesses.

"Their widespread failure would adversely alter the economic landscape of local communities and potentially slow the economic recovery and future labor productivity growth," the Fed said.

Lingering economic weakness can become problematic for larger companies, particularly those that have borrowed fresh debt. A majority of fund managers in the BofA survey believes companies should focus on reducing debt at the expense of capital investment and share buybacks.

A lengthy process of repairing balance sheets, with weaker companies defaulting and restructuring, suggests the economic recovery will be modest, but it also makes a case for owning areas of the corporate debt market. Companies that pay down their debt in the coming years and climb back up the credit-rating ladder are certainly appealing.

Already there has been a rush for corporate debt reflecting the presence of central banks. This week, the Fed waded deeper into this market by announcing exactly how it will purchase individual bonds sold by companies.

Naturally this has been well received by credit investors, but it also suggests a central bank very worried about financial stress. Rather than wait for pressure to build from rising defaults among weaker companies and ripple across the rest of the market, the Fed is getting well ahead of such an outcome.

That may stem some weakness in corporate debt, but a longer term cycle of defaults and business failures stands to shape both public and private credit markets over the next 12 to 24 months. Given the growing presence of the Fed within the public credit sphere, some think investors should devote more of their efforts to private markets for equity and debt instruments alongside real estate and infrastructure.

BlackRock contends that less liquid private markets help create "diversified portfolios that are more representative of the global economy than public markets alone".

Private equity firms are not hanging around, with deals worth more than US$40 billion ($62.4b) since March. And some big investors are also not waiting. Calpers, the US$395b fund that looks after the retirements of California's state workers, plans on boosting its use of leverage and its exposure to private equity and private debt in order to generate a 7 per cent return over the next decade.

Like many pension funds, the current climate of low rates leaves Calpers with few options. Either future promises made to retirees are eventually cut, or these institutional investors take on greater levels of risk in order to make the required rate of return.

Global pension funds now allocate more than a quarter of their assets to private markets, according to consultancy Willis Towers Watson. That is up from one-fifth in 2008 and given the current backdrop of highly supportive central banks and limited opportunities in public markets, that share is set to rise.

Pension plans and other investors could meet their return targets by taking advantage of dislocations across an indebted financial system. One danger, though, is that central banks' distortion of public markets and the resulting increase in leverage have created fertile conditions for more bouts of market instability.

Written by: Michael Mackenzie

© Financial Times