Amundi Q&A: Brexit and finding value

Myles Bradshaw, head of global aggregate fixed income at Amundi, talks to Room151 about how local authority pension funds and treasurers can find value, and the effect of the forthcoming Brexit referendum.

Room151: Local authority investors are facing major challenges finding security (which they’re not getting from unsecured bank deposits), yield (which they’re not getting in the low interest rate environment) and liquidity (which they have to forgo in order to get any yield). It’s the perfect storm. What do you recommend?

Myles Bradshaw: Firstly, it is worth putting this into some context – the UK is relatively better than many countries. In Europe you are talking about negative rather than low yields.

As an investor you have a few simple choices. You can either accept a lower return or take more risk through higher yielding securities. But you should expect greater volatility if you go down this route.

One alternative is to take more alpha risk. This is where you invest in a bond fund with a wider investment opportunity set. For example, rather than going into a Sterling bond fund you go into a global fund.

You can hedge out the volatility of the Sterling exchange rate and still benefit from a wider pool of investment opportunities: there are more issuers, more sectors and more national business cycles to bet on in terms of interest rate policies.

Diversification is a key benefit of going global because a wider pool of assets will be driven by many different fundamental factors.  For example, the outlook for milk prices is key for New Zealand but irrelevant for Italy.  Diversification enables a portfolio to be built with the same return by less volatility.

Room151: Do widening credit spreads indicate we are heading for recession again?

MB: Credit spreads are the difference between the yields on corporate bonds and government bonds. The bigger the gap the more risky the market thinks corporate credit is. If you look at the charts over the past 20 years you find that, unsurprisingly, credit spreads widen during times of recession when default rates pick-up.

Recently, credit has underperformed significantly. Oil prices have plummeted, banks are under pressure because of concerns over profitability. There are market concerns about the global growth outlook.

These issues have been exacerbated because the market is less liquid. A consequence of the regulations on banking introduced after the 2007 crisis means that banks have less incentive to warehouse bonds and carry principal risk in their market-making roles.

Valuations are currently consistent with a sharp pick up in default rates to recession-like high single digit levels.   But the economic data is not consistent with recession.

In other words, markets are offering high-risk premiums for uncertainty – you are being paid to take risk. We think, because of these risk premiums, now is a good time to invest in credit.

Why are investors cautious?  One reason is because assets are being sold for commercial rather than investment reasons.

Markets have suffered from large liquidations from sovereign wealth funds, particularly in oil producing countries. These countries have big deficits and are having to liquidate assets to finance these. China was acquiring assets but is now having to sell to support its currency.

Room151: Where can you see value currently?

MB: Corporate bonds overall look good value, and our preference here is for the financial sector. Within that we prefer the subordinated part – lower tier two debt. Financial companies’ balance sheets are robust – they have recapitalised and are now prevented from taking risks and being forced to hold more capital. We see very low risk of bail-in on the horizon.  While this environment of low profitability is not so good for equity investors, it suits bond investors as a less risky borrower is more likely pay coupons and give you your money back.

Room151: What do you think investors should be doing in preparation for the Brexit referendum in June?

MB: Up until June, I think, the key theme will be continued uncertainty:  the polls are showing an even split between ‘in’ and ‘out’ and the undecideds probably won’t make up their minds until close to the vote. My guess is that UK assets will come under more pressure – particularly the pound.

If there is a vote to “Remain”, I expect a sharp rally in UK risks including Sterling.  This is likely to lead to rising expectations for Bank of England interest rate increases. A vote to “Leave” will probably see sharp downward moves in risk assets, especially UK risks. How do you position for that? It is hard to have high levels of conviction at the moment, so the best bet is to use option markets to hedge the risks. It is fair to assume that Brexit would not just be a UK problem.  Brexit may raise question marks about other EU countries’ commitment while greater economic uncertainty will affect all European risk assets, not just the UK.
Look at your portfolio – if you own equities or credit, you probably stand to lose more from a “Leave” vote than you would gain from a vote to “Remain”.  Using option markets is a sensible way to hedge the tail risks to your portfolio.