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Taking a global approach to credit

25 October 2018

On the second anniversary of the Zurich Horizon Monthly Income Plus fund, fund manager Mike Della Vedova looks back on changes in the income market.

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As the Zurich Horizon Monthly Income Plus fund turns two, its manager Mike Della Vedova outlines the benefits of taking a global approach to credit.

Much has changed since we launched the Zurich Horizon Monthly Income Plus fund, not least the escalation in global trade tensions. Market volatility has risen, reminding markets that the ‘Goldilocks’ environment of excess liquidity, low rates and strong economic growth cannot last forever. While geopolitical concerns were partly behind the volatility, withdrawal of global liquidity and the move to a higher rate environment remain key risks.

Having ended its quantitative easing bond buying in 2014, the US Federal Reserve last year began reducing the size of its outstanding balance sheet and proceeding with steady interest rate hikes. The European Central Bank (ECB) tapered its monthly purchases in January 2018, with attention now focused on a potential further taper later this year. Elsewhere, the central banks of Canada and the UK implemented rate hikes in 2018, with the potential for additional rises in the year ahead.

The net result of this trend in developed market monetary policy is a less supportive environment. With valuations having become stretched, there is little cushion in most sectors for fixed income to absorb the shift to higher rates and heightened volatility.

Going Global

Against this backdrop, it is easy to become bearish on fixed income. However, a closer look at the shift in monetary policy reveals a growing divergence between central banks. We believe this divergence in the pace of normalisation presents global investment opportunities.

The ECB is lagging the Fed, for example. It has reassured markets that it will maintain its balance sheet through reinvestments of maturing bonds while also keeping rates on hold for the near term. We expect the ECB will continue to proceed cautiously.

The Bank of England, too, may tread more slowly on its path to rate hikes than the Fed, with inflation slowing in early 2018 alongside potential Brexit economic headwinds. Meanwhile, the Bank of Japan has repeatedly indicated it is still too early to begin unwinding its long-held stimulus program.

With valuations across fixed income stretched relative to history and fundamentals, casting a wide geographic net is increasingly important.

Countries around the world are at different stages in their growth and interest rate cycles, so credit strategies that invest globally can take advantage of unsynchronised credit cycles, value disparities and differing return potential across regions. These strategies can also exploit market dislocations and volatility triggered by macroeconomic and geopolitical developments. Investors can additionally benefit from cross-currency relative value analysis.

Opportunities in Volatility

Despite recent fissures in the synchronized global growth story, we view the recent slowdown as temporary normalisation following peak growth levels in 2017. While corporate fundamentals should remain favourable, the technical backdrop is becoming less accommodating.

Volatility creates opportunities as well as challenges, and an active management approach can help to identify value.

Strategies to adapt to the changing environment can be as straightforward as rolling down the curve and reducing duration. We also believe actively employing market-neutral strategies, such as pairs trades and barbell allocations, may offer further inflation protection. Investment strategies that are less highly correlated may benefit as well.

Positive on Credit

We believe economic growth should continue in the year ahead, supporting high-yield bonds. While we remain positive on credit in the short-to-medium term, the recent uptick in rates and volatility has weighed on the market and repriced credit risk. Against this backdrop, we believe credit selection remains key.

The Zurich Horizon Monthly Income Plus fund is a target income global credit strategy that aims to deliver stable income returns while protecting against the downside. As many core investment grade sectors currently offer minimal yields and high exposure to rising interest rates, we believe there is a benefit in gaining exposure to a broader opportunity set.

We seek to exploit a global opportunity set, both to find an attractive level of income, and to diversify and manage risk. Within this investment universe, our approach is one of careful security selection based on fundamental research.

Mike Della Vedova is a global high yield portfolio manager in the fixed income division at T. Rowe Price