Credit selection in a late-cycle environment



​Rebecca Young, Portfolio Manager within the Strategic Fixed Income team, shares her views on the topical issues in credit markets, explaining where she and the team see risks and opportunities.  

Economies do not grow evenly; there are ups and downs as an economy moves through the different stages of expansion (growth) and contraction (recession). Business activity follows the same patterns. The latest global economic expansion began nearly ten years ago and we firmly believe it is ‘late stage’, although it would appear that we are far from alone in this view. A record 85% of investors surveyed in a recent fund manager survey* think the global economy is in late cycle (11% higher than the previous high in December 2007).

Late-cycle can be a difficult time for credit investors as spreads tend to widen, completing a bottoming process ahead of a peak in equity markets. Hence we need to be vigilant to minimise the downside risk for any of our individual credit holdings. When looking specifically at the developed world credit markets, there are certainly a number of trends worth monitoring closely, and these are currently warning us to tread carefully.

Beginning with global leveraged loans…
Leveraged loans are loans to heavily indebted companies. The Bank of England recently warned that the leveraged loan market is now “larger than — and growing as quickly as — the US subprime mortgage market was in 2006”. Leveraged loans continue to benefit from their senior, more defensive position in the capital structure. However, the legal protections for investors to be able to hold borrowers to account should the financial performance of a business falter, have been significantly eroded, with nearly 80% of the US leveraged loan market now ‘covenant-lite’. This is up from less than 25% in the 2006-07 era.

We have witnessed leverage levels creeping higher and ‘loan-only’ structures becoming more prevalent. These are structures that lack a junior high yield bond component, which would normally provide loss absorption in the event of a default.

Thus, it is not surprising that the average credit quality of the US market has deteriorated, with approximately 64% of the outstanding stock now rated mid single B or below, versus 47% of the market in 2006.

…switching to bonds and the high yield market
In Europe this year, we have been monitoring the rising level of dispersion in bond prices, with a growing number of individual bonds experiencing large price drops. There are now nearly 70 bonds year-to-date that have dropped 10 points or more (figure 1). Avoiding these large potholes has been crucial for capital preservation. Interestingly, the ICE Bank of America Europe High Yield Index return has held up relatively well, declining  1.4% year-to–date (to 31 October 2018, in local currency terms), but when you dig down a little deeper under the surface, things are not as healthy as they first appear.

Figure 1: European high yield market: change in bond prices year-to-date

Source: Bank of America Merrill Lynch, Bloomberg, as at 30 October 2018

Next: the growing size of BBBs
Another frothy area of the credit market that has caught our attention is the growing size of BBB-rated debt (the lowest tier of investment grade). This phenomenon has played out across Europe and the US in this cycle, including where companies have voluntarily added debt to their balance sheets through merger and acquisition (M&A) activities.

The primary concern here is one of relative size of the BBB market versus the BB-rated category (the higher credit rating bucket of the junk bond market); where, for example in the US, the former is 4.3x the size of the latter and compares to twice the size ten years ago.

The rapid growth of BBB markets in Europe and the US can be seen in figure 2. In the next downturn, there will inevitably be some downgrade activity from BBB to BB but will the BB category suffer from indigestion as it is forced to absorb these downgrades?

Figure 2: Rapid growth of BBBs

Source: Credit Suisse, as at March 2018

So where can we take shelter in the credit markets?
Given this backdrop for credit, we have felt it prudent to gradually upgrade the quality of the portfolios over the past few years, with a preference for higher quality credit and government bonds at the expense of high yield credit.

One theme we continue to favour is that of ‘rising stars’; companies where we are confident in the health of the underlying business, and which are also transitioning from high yield to investment grade. Over this journey, credit spreads tend to tighten and bond prices rise, providing a potential income and capital appreciation opportunity.

An example of this dynamic is CyrusOne, a US-listed data centre company that was recently upgraded to BBB  by Standard & Poor’s. The company is laser-focused on getting a second upgrade at Moody’s, motivated by the potential to drive down their cost of borrowing. Two investment grade ratings provide for a positive technical backdrop as bonds see demand from a whole new buyer base since the securities become investment grade index eligible.

Tesco is another rising star example, recently obtaining their first investment grade rating from Fitch, and the company has been actively tendering for bonds in the market to strengthen its balance sheet.

‘Strategic assets’ is another theme of note, specifically companies where we are comfortable with the business fundamentals but also think there is potential for a positive catalyst through M&A activity. For example, our holding in the high yield German cable company Unitymedia, which benefited earlier this year when Vodafone agreed to buy the company. The news sent Unitymedia bond prices higher given that the bonds will be absorbed into the higher quality, investment grade capital structure at Vodafone, on closing of the deal.

In summary, credit-positive stories are certainly becoming harder to find in this late-cycle environment but they do still exist. Thus, we continue to spend our time trying to seek out these opportunities and remain highly selective in terms of the credits we add to our portfolios.

* Bank of America Merrill Lynch Global Fund Manager Survey, 16 October 2018


These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

For promotional purposes.

Important information

Please read the following important information regarding funds related to this article.

Janus Henderson Horizon Strategic Bond Fund

This document is intended solely for the use of professionals and is not for general public distribution.

The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Any investment application will be made solely on the basis of the information contained in the Fund’s prospectus (including all relevant covering documents), which will contain investment restrictions. This document is intended as a summary only and potential investors must read the Fund’s prospectus and key investor information document before investing. A copy of the Fund’s prospectus and key investor information document can be obtained from Henderson Global Investors Limited in its capacity as Investment Manager and Distributor.

Issued in Europe by Janus Henderson Investors. Janus Henderson Investors is the name under which investment products and services are provided by Janus Capital International Limited (reg no. 3594615), Henderson Global Investors Limited (reg. no. 906355), Henderson Investment Funds Limited (reg. no. 2678531), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), (each registered in England and Wales at 201 Bishopsgate, London EC2M 3AE and regulated by the Financial Conduct Authority) and Henderson Management S.A. (reg no. B22848 at 2 Rue de Bitbourg, L-1273, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier). We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

Past performance is not a guide to future performance. The performance data does not take into account the commissions and costs incurred on the issue and redemption of units. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. If you invest through a third party provider you are advised to consult them directly as charges, performance and terms and conditions may differ materially.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

The Fund is a recognised collective investment scheme for the purpose of promotion into the United Kingdom. Potential investors in the United Kingdom are advised that all, or most, of the protections afforded by the United Kingdom regulatory system will not apply to an investment in the Fund and that compensation will not be available under the United Kingdom Financial Services Compensation Scheme.

Copies of the Fund’s prospectus and key investor information document are available in English, French, German, and Italian. Articles of incorporation, annual and semi-annual reports are available in English. Key Investor document is also available in Spanish. All of these documents can be obtained free of cost from the local offices of Janus Henderson Investors: 201 Bishopsgate, London, EC2M 3AE for UK, Swedish and Scandinavian investors; Via Dante 14, 20121 Milan, Italy, for Italian investors and Roemer Visscherstraat 43-45, 1054 EW Amsterdam, the Netherlands. for Dutch investors; and the Fund’s: Austrian Paying Agent Raiffeisen Bank International AG, Am Stadtpark 9, A-1030 Vienna; French Paying Agent BNP Paribas Securities Services, 3, rue d’Antin, F-75002 Paris; German Information Agent Marcard, Stein & Co, Ballindamm 36, 20095 Hamburg; Belgian Financial Service Provider CACEIS Belgium S.A., Avenue du Port 86 C b320, B-1000 Brussels; Spanish Representative Allfunds Bank S.A. Estafeta, 6 Complejo Plaza de la Fuente, La Moraleja, Alcobendas 28109 Madrid; Singapore Representative Janus Henderson Investors (Singapore) Limited, 138 Market Street, #34-03 / 04 CapitaGreen 048946; or Swiss Representative BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich who are also the Swiss Paying Agent. RBC Investor Services Trust Hong Kong Limited, a subsidiary of the joint venture UK holding company RBC Investor Services Limited, 51/F Central Plaza, 18 Harbour Road, Wanchai, Hong Kong, Tel: +852 2978 5656 is the Fund’s Representative in Hong Kong.

Information on this document is on Janus Henderson Investors’ best endeavours.

Specific risks

  • This fund is designed to be used only as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this fund.
  • The Fund could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Fund.
  • The value of a bond or money market instrument may fall if the financial health of the issuer weakens, or the market believes it may weaken. This risk is greater the lower the credit quality of the bond.
  • Changes in currency exchange rates may cause the value of your investment and any income from it to rise or fall.
  • If the Fund or a specific share class of the Fund seeks to reduce risks (such as exchange rate movements), the measures designed to do so may be ineffective, unavailable or detrimental.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Any security could become hard to value or to sell at a desired time and price, increasing the risk of investment losses.

Risk rating


Important message