5 ways to approach corporate bonds in a late-cycle economy | Capital Group Canada | Insights



5 ways to approach corporate bonds in a late-cycle economy

Damien McCann, fixed income portfolio manager

In this low rate environment, investment-grade and high-yield bonds can provide returns, particularly for investors seeking income.

Amid low interest rates, investors continue to look for sources of yield, and corporate bonds have garnered substantial interest. But in the late stages of an economic cycle and with very tight credit spreads over U.S. Treasuries, how should investors approach credit markets? We spoke with portfolio manager Damien McCann to get his take.

1. Given the current macroeconomic backdrop, how are you positioned in credit portfolios?

Economic data will remain a bit soft in the U.S. I don’t expect economic growth to accelerate to the levels that we were experiencing a year ago. That said, the recent softening seems more indicative of a leg down in the current cycle rather than the start of a recession. The U.S. Federal Reserve also maintains an accommodative stance, as we have seen with three interest rate cuts this year. Against this backdrop, I am not in a bunker in terms of how I’m building credit portfolios. Rather, it’s a modestly defensive positioning.

2. How do you plan to add value in these portfolios?

I may be oversimplifying this, but in a credit portfolio, one way to generate excess returns, or alpha, is to take a view on the direction of corporate bond spreads and be a lot more or a lot less aggressive than the market benchmark. That is one lever available to investors, but it tends to result in periods of significant underperformance whenever aggregate credit spreads move against your view.

But there’s another, what we think is a more reliable approach, which is generating returns through security selection. That means picking the right corporate bonds that have their own idiosyncratic drivers, which means they move in price based on factors that are specific to those companies and not just the macro environment. My aim is to more consistently add alpha in most market environments by identifying companies where, working with our equity analyst counterparts, we see improving fundamentals or other catalysts for gains.

3. There is a lot of focus and market attention on corporate leverage. How does that factor into your thinking and approach?

There is no doubt that corporate debt and leverage have steadily increased since 2008. Loan covenants are less stringent in many cases, and there are signs of stress in some areas of the market. There’s also considerable concern about the growth of BBB bonds to US$2.9 trillion, roughly quadruple the levels of 2008. That said, it’s important to not paint the entire market with one brush. As active managers, it’s our job to identify areas of opportunity. Our credit investment analysts talk to corporate executives regularly to identify companies with credible deleveraging plans and solid long-term strategies.

Some of the increase in leverage has come from companies with noncyclical cash flows borrowing to fund acquisitions made for — what are in my view — strategically sound reasons. For example, in pharmaceuticals, Japan-based Takeda largely debt financed its acquisition of U.K.-based Shire. In health care, Cigna borrowed in the capital markets to acquire Express Scripts. And in the food industry, Conagra issued bonds to purchase Pinnacle Foods. All three acquisitions resulted in economies of scale as well as complementary businesses or products. And all three acquirers are now actively reducing leverage with free cash flow and asset sales.

Also, we are now seeing a tapering off in the pace of leverage increases among corporations, and this should continue as M&A activity has slowed down. While varying by industry, proposed acquisitions have faced more resistance to regulatory approval, giving acquirers pause. Trade uncertainty has also led companies to push out their capital expenditure plans.

4. If we do see an economic downturn or a shock to markets, what options do companies have to avoid a credit event?

Big picture, I’d say many companies can avoid a downgrade by selling assets, slashing capital expenditures, reducing dividends and/or issuing equity. These steps may not be good for stock investors, but they would be beneficial to bondholders. While none of these options are easy, it’s often preferable to a downgrade to high-yield status, which often results in higher borrowing costs and less access to financing at what may be precisely the wrong time.

While we are likely to see downgrades from investment grade to high yield during the next downturn, as we do in each down cycle, I think the level of downgrades is more likely to resemble past cycles, rather than something extraordinary.

5. Where are you finding value in corporate bonds?

I tend to buy bonds of companies that I think are cheap based on fundamental credit theses that may take years to play out and require that we take a long-term approach.

Within investment-grade corporates, I’m positive on select large pharmaceutical companies. They may have leveraged up to do an acquisition, but there’s high visibility of free cash flow, so they can deleverage quickly. And the business models tend to be very resilient in economic slowdowns.

Meanwhile, in the energy sector, many issuers remain cautious with their balance sheets after the sharp oil price decline we saw several years ago. At the same time, new project investments will likely lead to higher earnings, and planned asset sales should result in some deleveraging of balance sheets.

In high yield, we also see opportunities in pharmaceuticals, especially in companies that are deleveraging and selling assets. Another set of companies that interests me are the fee-based data-centric technology companies that enjoy very sticky demand and generate free cash flow capable of servicing elevated debt loads even in periods of economic downturn.

On the rating spectrum, BB-rated corporates look overvalued on average, while CCC-rated corporate bond spreads have drifted wider and now offer value in select pockets. Companies are rated CCC because they have issues, so one must be very careful and the credit selection has to be backed by very intensive analysis, but there are investment opportunities to be found.

All in all, my current focus is on companies that are less sensitive to the economic cycle or have clearly laid out deleveraging plans. And being selective is key — not by sector, but a company-by-company, credit-by-credit selection.



Damien McCann Fixed income portfolio manager

Damien McCann is a fixed income portfolio manager with 20 years of investment industry experience. He previously covered energy, leisure and lodging, and rail companies as a fixed income investment analyst at Capital Group. He earned a bachelor’s from California State University, Northridge and is a CFA charterholder.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

Unless otherwise indicated, the investment professionals featured do not manage Capital Group‘s Canadian mutual funds.

References to particular companies or securities, if any, are included for informational or illustrative purposes only and should not be considered as an endorsement by Capital Group. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds or current holdings of any investment funds. These views should not be considered as investment advice nor should they be considered a recommendation to buy or sell.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not be comprehensive or to provide advice. For informational purposes only; not intended to provide tax, legal or financial advice. We assume no liability for any inaccurate, delayed or incomplete information, nor for any actions taken in reliance thereon. The information contained herein has been supplied without verification by us and may be subject to change. Capital Group funds are available in Canada through registered dealers. For more information, please consult your financial and tax advisors for your individual situation.

Forward-looking statements are not guarantees of future performance, and actual events and results could differ materially from those expressed or implied in any forward-looking statements made herein. We encourage you to consider these and other factors carefully before making any investment decisions and we urge you to avoid placing undue reliance on forward-looking statements.

The S&P 500 Composite Index (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2020 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.

FTSE source: London Stock Exchange Group plc and its group undertakings (collectively, the "LSE Group"). © LSE Group 2020. FTSE Russell is a trading name of certain of the LSE Group companies. "FTSE®" is a trade mark of the relevant LSE Group companies and is used by any other LSE Group company under licence. All rights in the FTSE Russell indices or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indices or data and no party may rely on any indices or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company's express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication. The index is unmanaged and cannot be invested in directly.

Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, "Bloomberg"). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, "Barclays"), used under licence. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

MSCI does not approve, review or produce reports published on this site, makes no express or implied warranties or representations and is not liable whatsoever for any data represented. You may not redistribute MSCI data or use it as a basis for other indices or investment products.

Capital believes the software and information from FactSet to be reliable. However, Capital cannot be responsible for inaccuracies, incomplete information or updating of the information furnished by FactSet. The information provided in this report is meant to give you an approximate account of the fund/manager's characteristics for the specified date. This information is not indicative of future Capital investment decisions and is not used as part of our investment decision-making process.

Indices are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

All Capital Group trademarks are owned by The Capital Group Companies, Inc. or an affiliated company in Canada, the U.S. and other countries. All other company names mentioned are the property of their respective companies.

Capital Group funds and Capital International Asset Management (Canada), Inc. are part of Capital Group, a global investment management firm originating in Los Angeles, California in 1931. The Capital Group companies manage equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.

The Capital Group funds offered on this website are available only to Canadian residents.

Related Insights