09 January 2020
Utilities and real estate offer opportunities
The UK utilities sector still trades on wider spreads relative to peers. With nationalisation fears now firmly off the table after the UK Labour party were resoundingly defeated in the election, we expect some strong spread compression in the sector. While there are still some operational challenges, which we are monitoring, companies such as Thames Water have been trading significantly wider than the sector average but offer potential outperformance.
We are also positive on the real estate sector, particularly commercial and social housing property. Political clarity will allow market transactions to pick-up in this space and while this may result in further valuation declines, fixed income investors should be well protected.
The asset-backed securities universe is an area we continue to like. Meanwhile, whole-business securitisations such as the AA and RAC look attractive given the yields on offer; yields are comparable to those of some high yield bonds while still offering the better risk profile of IG.
Ostracism of sterling IG has created relative value
When looking at valuations in the IG space more broadly, it is hard to see a repeat of 2019-type returns. Instead, returns are likely to be driven by carry. While absolute levels seem to be fairly valued, the ostracism of sterling IG credit has created value relative to US and euro IG. As the chart below shows, the additional spread compensation offered to investors for investing in sterling IG relative to US and euro IG is 30-40 basis points. This is particularly attractive given the low-yielding environment, which we expect will persist in 2020.
UK assets including sterling IG credit have been underweighted by the market for some time. But we expect this to change and flows into sterling IG credit, which have been flat relative to other fixed income asset classes (see below), to accelerate. With reduced political uncertainty, we also expect M&A activity to pick-up which will offer up risks and opportunities for active investors.
Source: J.P. Morgan, Bloomberg, January 2020.
Defensive characteristics are helpful late cycle
While there is euphoria in global risk assets as we start 2020, we must be mindful that we are undoubtedly late in the economic and credit cycles, and this warrants caution. The sterling IG credit market offers the advantage that it is structurally more defensive than other sectors.
For instance, stable cash generative and non-cyclical sectors such as utilities make up more of the sterling universe relative to its euro and US counterparts. On top of this, higher-beta and cyclical sectors such as financials, make up less of the sterling universe relative to the US and euro markets.
Return of credit fundamentals
Overall, we are optimistic for sterling IG in 2020 and are approaching the year with greater conviction around making investment decisions based on credit fundamentals. Credit fundamentals had taken a backseat to political headlines for the last three years but will now matter more to returns. While the UK is still not totally in the clear, political uncertainty has lessened relative to the global political backdrop and we expect sterling IG credit to outperform its global counterparts.
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