Jenna Barnard discusses how the retail fixed income team has adapted its investment style in response to clues about where we are in the credit cycle.

For some time now we have been highlighting the strong signals coming out of the US corporate bond markets, which since mid-2014 have been definitively indicating caution as shown by the widening of thecredit spread (see chart). The credit spread is the additional yield on offer above that of an equivalent maturity government bond to compensate investors for the additional risk of a corporate bond. The increased spreads suggest that the credit cycle - a measure of the ease and ability of corporates to borrow for debt refinancing, capital expenditure and other spending - has turned.

The bear market in corporate bond spreads began in June 2014

Source:Bank of America Merrill Lynch, option adjusted spreads (OAS), US investment grade index (C0A0) and US high yield index (H0A0), Bloomberg, as at 14 December 2015

This reflects the increasingly risky behaviour of US companies. With interest rates still low and a steady stream of willing investors, US corporates have continued to binge on easy debt. The investmentgrade bond market in particular has been saturated by debt issued to finance merger and acquisition activities and stock buybacks - all classic late business cycle corporate activities. Within US high yield, while problems are mainly in specific sectors, such as commodities, increasingly the distress ratio - the number of bonds trading below 80 cents in the dollar - has begun to spread to other sectors as well.

We have voiced our concerns about the rise in the levels of distressed bonds in the US for months through our twitter account and other means. The distressed universe is now a significant percentage of theUS high yield index - nine per cent of this index trades at less than 60 cents on the dollar, versus one per cent in European high yield*. The shale boom was financed by US high yield bond investors but the distressed issue has now spread beyond commodities. The financial sector, however, is not among these, given continued re-regulation of the sector.

A rare Europe-US pide

Meanwhile in Europe, this trend is not evident. A lack of exposure to commodities and fewer large zombie companies in Europe have partly contributed to this, as well as the two crises in the last fiveyears. Hence, there is a big fundamental pergence at play, with the US in a very late-cycle stage, while Europe hovers in its mid-cycle. As European markets often follow the US, the concern is when would this anomaly disappear? We do not believe it will happen any time soon, as the conditions on the ground are very different in Europe.

The slowly rising default rates, and the current low growth, low inflation world can be threats to all fixed income portfolios. However, the pergent monetary paths ofcentral banks, as well as pergent corporate and sector behaviour, present opportunities for active asset allocation and stock selection, provided one reads the signs correctly.

Choosing the right path

Experience can leave a few clues for bond managers to follow. The first is always to recognise and accept which part of the cycle we are in. Creditor-unfriendly activities are clearly a sign that we areapproaching the latter end of a cycle. People invariably become bullish at this stage, seeking value where there is none. At a time when the market becomes saturated with bond issues by a plethora of different entities, it is essential to identify and avoid value traps. One example is frontier industries, often with an appealing equity story, such as US shale gas, but which ultimately fail to deliver on performance.

Patience and perspective

As bond managers, our portfolios reflect the turn in the credit cycle. We have been aware of these signs for a number of years now and have refused to follow the herd mentality of chasing higher yields. Our years of experience, having lived through a full cycle, have taught us that patience will reward in the end.

Thus, we did not invest in many deals presented to us in this cycle, perceiving them as value traps, choosing instead to continue to lend to large, non-cyclical companies, which in our view, representsensible investments. These entities typically have relatively reliable earnings and a moderate amount of debt on their balance sheets, which gives them the ability to pay a reasonable coupon.

It has not been an easy task to hold back on investments, and to let clients know that we are deliberately doing 'nothing'. However, in recent months, we have significantly increased the cash levelswithin portfolios, waiting patiently for the opportunities that we knew would emerge. Our experience and investment style has served us well, as we delivered a good relative performance in 2015. With a lot of negative news already priced in the markets, we believe 2016 could be even better.

*Citi, as at 14 December 2015