Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined by Fraser Lundie, Head of Credit for Hermes.
Hi, Fraser.
Fraser Lundie: Hi. Good morning.
Wall: So, we have been looking at the bond market and things have finally started to change. We're finally seeing in the U.S. bond yields start to rise. I suppose the question is, how much further do they have to rise for them to look like an attractive income opportunity?
Lundie: It's a fair question. The answer probably is not too far from here. Particularly, from a global point view, as a European investor, the yields on offer have started to look attractive and that ultimately can be a pain trade for a lot of credit actually because first of all you are losing money on a relative value basis to something that's starting to yield interesting levels, but secondly, a lot of the debt held by some credit is floating rate and as the yields rise, that becomes more of a pain trade on the interest coverage level.
Wall: And where U.S. goes, we are expecting the U.K. and Europe to follow, but I suppose how long that lag time is, is the question mark, right?
Lundie: Absolutely. And again, it is a bit of a relative value game. So, where the U.S. too experience further rising yields, to some extent that will have to bring Europe with it. But at the same time, Europe still has a long way to go and has some pretty unhealthy banks that need to go further down the root of balance sheet repair and there is a lot of political risk which is probably going to keep volatility intermittently heightened. That's going to make it difficult for things to move, I think, certainly in the short-term.
Wall: Well, there is the tailwind of inflation, isn't there, sort of, knocking on the centrals bank's doors? We've had 2.3%, the latest inflation figure here in the U.K. and I believe there is similar sorts of inflation in Germany and other parts of Western Europe. Does that help to move the process along?
Lundie: To some extent, but I don't really see materially higher levels from here because there is just simply too much capacity in the world. We continue to go around in a circle where this excess capacity is continuing to put downward pressure on prices. That's obviously continuing to make QE a necessity and that in turn is pushing more and more money into credit which is keeping companies alive and therefore capacity high. So, until that cycle breaks, I don't see a material change in the current outlook.
Wall: So, it doesn't sound like you're too bullish on developed market bonds. Does that mean that you're seeing better opportunities in emerging markets?
Lundie: Yeah, I think, the difficulty we have right now in a lot of low-quality developed market credit is that it is very constrained by the option held by the company. So, essentially, bonds cannot go up beyond a certain level. And that is a big deal when you're talking about low-quality credit, because low-quality credit by its very nature is closer to equity-type risk. You do buy equities, they can go up; you probably shouldn't be buying CCC bonds that can go up.
Now, the good thing about things like emerging market credit or falling angels, companies that used to be investment-grade is they don't typically have these call options in their bonds. So, conversely, they actually look quite attractive to us at this point.
Wall: Now, you did mention risk there because that's the thing that people are wary of in emerging markets. The whole thing about a low-yielding environment means that we've been pushed up the risk scale. You have a look at something like Brazil where both the government and corporate bonds are yielding incredible income that looks very attractive, but Brazil has a very shaky underlying economy, doesn't it?
Lundie: It does. So, I think, really the best risk-adjusted return trade would be to find companies in places like Brazil who are not necessarily overly Brazilian. So, something like Vale, for example, which essentially is a pure-play iron ore to China trade and therefore is not really that much to do with Brazil, certainly in a revenues sense. That to me is a sensible place to be allocating capital right now.
Wall: So, you're looking at perhaps companies that are listed in emerging markets but their revenues are more international?
Lundie: Exactly. And I think if you go down that route, you to some extent, have a natural hedge in the sense that these are dollar revenue companies. People tend to worry about dollar strength when they are thinking about emerging market for a good reason.
But if you have that natural hedge of dollar revenue local currency cost base then I think actually there's significant opportunity, not just in Brazil but if you look right across the board in places like Mexico and Russia as well, you see some good global corporates who perhaps are still offering too much of a premium.
Wall: Fraser, thank you very much.
Lundie: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
