As the dust settles after the enormous market volatility in March and April, we are all having to reset our expectations for asset class returns. The prospects for capital gains, income and liquidity have changed. In this new and still unpredictable environment, investments in global investment-grade credit offer the potential for all three.
While still digesting the impacts of COVID-19 and the consequent global lockdowns, it is clear to us that some sectors look extremely challenged fundamentally. Nobody can yet be certain whether we will look back on this as a short period of demand destruction, or something that changes the way we operate in society forever. Fundamental analysis in those areas most impacted is extremely difficult and needs to focus largely on liquidity; can these operators survive through a sustained downturn? Corporate issuers in these sectors are a very small part of the global investment-grade credit universe with aerospace, airlines, gaming, lodging, entertainment and restaurants collectively amounting to just 1.5% of the global investment-grade credit bonds outstanding, according to the Bloomberg Barclays Global Credit Index. The remaining 98.5% of the universe is more robust and can be modelled for significant contractions in global growth. Take the banks for example—central bank stress tests continue to report on the considerable capital build in this sector and we expect resilience for quality banks, even down the capital structure in subordinated bonds. Many non-cyclical credits are well positioned with healthy balance sheets and sizeable liquidity buffers. There will be downgrades and losers within global IG, given the extremity of the economic shock, but we think valuations are compelling for fundamentally stronger names, bringing opportunities for capital gains.
So what about income? Our global investment-grade credit strategy carries a yield of approximately 3%, with only a modest overweight to credit beta, or market risk. That compares to approximately 1% for the Global Aggregate Bonds Index, and considerably less for developed world global government bonds. Turning to equity markets, the recent swathe of dividend cuts and suspensions is a challenge for global investors seeking income and brings considerable uncertainty as to dividends being paid over the coming quarters. The correction in stocks has made dividend yields more attractive than at the start of the year given the fall in equity valuations but even now the S&P 500’s dividend yield is only around 2%. In Europe, meanwhile payouts may be as much as 50% lower in 2020 than in 2019 and dividend futures still price further dividend cuts.
Liquidity was always a hallmark of investment grade credit, but in late March even US Treasuries were struggling to trade efficiently. Since then we have had a considerable central bank response, with a keen eye on restoring liquidity to not only government bond markets but also to investment-grade credit markets. For the first time starting on May 12, the Federal Reserve is buying US investment-grade corporate credit, initially via ETFs, and states in its objectives that it wishes “to facilitate orderly repositioning and pricing of risk.” Meanwhile, the BoE has resumed its corporate asset purchases and the ECB has increased the size of its programmes. These schemes may not serve to send spreads meaningfully tighter but they will provide a meaningful liquidity backstop in times of crisis and have enabled corporates to issue bonds actively once again in the primary markets.
With credit spreads meaningfully wider, we believe investors can take advantage of the current market dislocations and generous concessions to buy assets at historically attractive yield spreads. Dispersion in returns is likely making security selection paramount and a wider global opportunity set desirable. Our bias in the near term is on high-quality issuers that can endure through a prolonged period of economic uncertainty; there is no need to reach for more precarious credits. We expect to see ongoing interest in the asset class.