Many investors were surprised by the European Central Bank’s (ECB) announcement that they would begin purchasing investment-grade corporate debt to help ease financing conditions in a struggling Eurozone economy. While positive for the economy, the ECB’s decision to buy the debt of investment grade-rated non-financial European companies will likely accelerate the downward pressure on corporate credit yields, making it even more difficult for European investors to meet their investment return targets. Likewise, across the globe, the implementation of negative interest rates in Japan is having a similar effect on Asian investors’ ability to source yield.
But things are not be as bleak as they may appear. Through a combination of policy tightening in the United States, changes to the inbound bond market purchasing quota in China, and actions by the ECB, there are now, what some may think of as unorthodox solutions for European investors that will allow them to increase yield without necessarily having to increase risk.
With the recent action by the ECB making it harder to get yield, one of the first unorthodox solutions for investors to consider is lightly managed, target duration, U.S. credit strategies. If I break this down, lightly managed is similar to buy and hold in that turnover is significantly lower (less than 10% per annum) than traditional actively managed strategies and trading typically only occurs to replace maturing bonds or address credit concerns. The sweet spot of targeted duration is between three and five years, where we are already starting to see increased demand from investors. And last, the U.S. credit component. U.S. credit can offer significantly higher yields than European investment grade bonds by holding on to them rather than trying to generate alpha from total return opportunities. Historically, this goes against what has traditionally been the case in Europe where corporate credit investing has been more actively managed. The shift to harvest yield will only precipitate this trend.
Another unorthodox solution for investors to consider is tapping into parts of the U.S. market historically only accessed by U.S. investors, like U.S. municipal bonds and mortgage derivatives. For starters many U.S. municipal bonds provide higher yields than U.S. Treasurys and have low correlations to other fixed income asset classes. In addition, they have significantly lower default rates than U.S. investment-grade credit and European investors have almost no exposure. On the other hand, mortgage derivatives, representing pools of agency U.S. mortgages, have no exposure to corporate credit risk and are a non-credit option for those who fear the end of the credit cycle and can be structured to have low sensitivity to rates. Overall, U.S. municipal bonds and mortgage derivatives offer diversification benefits to European investors who are looking to de-risk by lowering exposure to highly concentrated parts of their portfolios.
The last unorthodox solution for investors to consider is taking advantage of the opportunities created by recent regulatory shifts in Europe and China. Despite the recent negative performance of bank stocks, bonds, and capital securities, the ECB appears to have given banks the tools to protect the earning capacity by allowing them to borrow from the ECB at negative rates; thereby shifting the delivery mechanism of quantitative easing away from weakening the currency and back to encouraging lending. This is good news for banks and benefits investors. Strategies that invest across the capital structure of global banks will take advantage these regulatory shifts and provide investors with an alternative solution that has low correlation to rates and equities with an investment grade credit quality bias. In China, the People’s Bank of China recently removed an inbound quota that permits access to the third largest bond market in the world (behind the United States and Japan) for non-Chinese investors. The yield on one-year Chinese sovereign debt is approximately 2.2% and the yield on one-year quasi sovereigns is approximately 1.0% higher. These yields are still attractive for investors seeking short-dated, high-quality fixed income solutions, even after you subtract approximately 1.2% to hedge the currency.
Recent moves by the ECB late last week will make it much harder for European investors to attain their yield targets going forward and will need to find new avenues in order to do so. At first glance, to achieve these yield targets it would seem the logical solution would be add more risk to your portfolio, but we believe that is not necessarily the case. The real solution is to think differently and look outside the box of traditional investment options.
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