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Stability Grabs Hold Of Credit Mart, Prompting Returns Concerns

Credit market participants are turning increasingly bullish on fundamentals for the second half of the year, noting the market has so far withstood the upheaval generated by the General Motors and Ford Motor Co. downgrades to junk, rising interest rates and even the London bombings.

Credit market participants are turning increasingly bullish on fundamentals for the second half of the year, noting the market has so far withstood the upheaval generated by the General Motors and Ford Motor Co. downgrades to junk, rising interest rates and even the London bombings. But on the flip side, far from concerns about a spike in default rates, they are now concerned about finding ways to generate excess returns for the year if the market stays flat. Some investors are even shortening duration in an attempt to generate additional alpha on the rates side.

"When people saw the market hold after the terrorist attack in London, they started to feel better about the market," said Dale Spencer, portfolio manager at Aladdin Capital Management in Stamford, Conn. He noted after the mass transit attacks on Madrid and London, bond investors bought on weakness. Furthermore, he added the consensus the Federal Reserve is nearing the end of its rate increases suggests spreads will not widen as historically the market rallies at the end of the tightening cycle. He expects modest returns for the remainder of the year and sees some value in the cross-over space and homebuilders such as D.R. Horton and K.B. Homes.

"I don't see anything nasty coming on the horizon; there aren't any high-risk situations brewing," agreed Angelo Manioudakis, portfolio manager at OppenheimerFunds in Boston, which manages $10 billion in investment-grade fixed income. Despite his view the market is stable, Manioudakis noted he has cash on the sidelines because corporate valuations are not attractive enough to add paper. "Where are we going to get excess returns from? There aren't many appealing options," he noted.

Krishna Memani, managing director and global head of credit strategy at Credit Suisse First Boston, is anticipating roughly 50 basis points of return from carry from the CSFB Liquid U.S. Index and an additional 30bps from additional spread tightening. "We believe the second half of the year will be better, but it doesn't take a whole lot to be better than the first half," he quipped. The first half of the year returned negative 100bps to credit investors, according to CSFB. Memani noted solid earnings, good stock performance, low equity volatility and small net supply point to stable credit spreads ahead. He is recommending investors buy cross-overs, real estate investment trusts (REITs) and brokers.

Manioudakis, for one, is taking an extreme short duration stance on the view interest rates will rise in his attempt to generate returns. "We just went through an internal process where we went through all of the names we think are cheap...We looked at the number of basis points we would squeeze out of [them] and tried to quantify all of our best ideas and it was not a big return relative to normal," he said. Oppenheimer has maximum shorts across its funds, noted Manioudakis, declining to quantify his duration call. It is also overweighting triple-B credits.

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