Inflation: Negative real yields or negative convexity?
Asia-Pacific Private Credit Newsletter
We ended our last Newsletter by highlighting a chart from Deutsche Bank which showed 85% of the US high yield market yielding below US CPI. At that time (September), headline US CPI was 5.4%, which created a negative gap of around 1.5% (based on a nominal yield of 3.9%).
Since then, the market has been struggling with whether higher US (and global) inflation will be “transitory” vs. “persistent”. Last week it became much clearer that the “persistent” camp is winning. Headline US CPI came in at 6.2% for October. What is more, the underlying numbers suggest that inflation is getting broader and stickier, as the price of goods and services that adjust slower than others join the upwards advance.
Real yields are getting crushed…
We haven’t seen Deutsche repeat their analysis, but with the US High Yield Index yield currently averaging 4% and change, we’d guess the percentage of the market trading at negative real rates must be nudging nearer to 100.
These levels have seen issuers rush to the market in recent days as they seek to lock in low coupons while they still have the chance. 2021 issuance is set to surpass previous peaks of 2020 and 2012.
Many investors will see a 4% yield as – literally – better than nothing. At these levels and with relative short duration, US high yield still offers some cushion in the event of rising interest rates. If an investor’s mandate allows, it’s worth taking the higher risk of default. Other parts of the market offer much lower yields and much higher interest rate risk despite the higher credit quality.
As a reminder of how low expected returns have gone, the following chart illustrates the disturbing fact that more than a fifth of the bonds issued by governments and corporations across the globe are trading at negative yields:
INFLATION: WHAT IT MEANS FOR YOUR PORTFOLIO...
In this Newsletter we discuss the risk of persistent higher inflation to fixed income assets and ask whether APAC private debt could be a buffer against negative real yields and negative convexity:
1. Thematic focus -Inflation and what it means for your portfolio...
2. News centre - Links to several articles and white papers we found interesting
Source: Deutsche Bank Research as at 7 September 2021, Zerobridge's scribbles as at 12 November 2021
Other developed central banks are walking similarly fine lines. In the UK, for instance, the Bank of England earlier this month stepped away from a widely-expected first rate rise from record lows. Many emerging market central banks have already begun tightening.
Negative real yields or negative convexity?
Investors’ fixed income books are faced with two equally unattractive scenarios to manage.
One scenario is that, for the short term at least, nominal rates lag and inflation ticks up a little more, leading to real yields getting crushed further, for longer. An alternative is the risk that developed banks suddenly accelerate the pace and magnitude of rate rises in response to persistent inflation. This would result in capital losses for bonds, particularly those with lower coupons and/or longer tenors (those that display the most negative convexity).
The healthy ongoing demand for US high yield paper shows that, given this balance of risks, credit instruments with healthy coupons and shorter tenors should remain attractive to investors. However, navigating these risks will not be easy. Any portfolio adjustment that occurs between these two choices is only about risk mitigation, rather than achieving real return outcomes.
A portfolio problem…
As discussed earlier, low bond yields were already a problem before recent months’ inflation numbers. Earlier in the year, one global asset manager published a report that observed that the average US public pension plan has a 23% allocation to fixed income, with around half of this in domestic “core bonds”. The manager’s central expected 10-year return on this asset class was 1.4% which means that – at just under a quarter of the total allocation - fixed income is expected to contribute less than 5% of the overall target return of a hypothetical US public pension plan. (The actuarial assumed return for a US public pension plan is usually 7%). That’s a lot of heavy lifting to be done by the portfolio’s “risk assets”.
… with a private markets solution?
For plans that can trade liquidity for higher returns, the manager advocates an allocation to private credit, funded potentially from core bonds. In their view, such strategies potentially offer stronger covenants and better downside mitigation than public market equivalents. For those plans able to increase the risk of their debt portfolios, the manager says opportunistic private credit strategies can also be considered, which offer the potential for upside participation. Data show that US pensions have tended to under-allocate to opportunistic strategies.
It’s safe to assume that these data reflect allocations to US-focused private credit strategies. Although we are aware of some US public pensions allocating to APAC private credit funds, the region still only accounts for around 7% of AUM globally.
Zerobridge Partners Asset Management Limited is focused on giving institutional & high net worth investors globally access to APAC alternative credit opportunities. The strategy seeks to take advantage of the less developed banking and capital markets in the APAC region and capitalize on our strong proprietary deal flow.
Zerobridge Partners Advisory Limited is a debt advisory firm focusing on raising new capital, creditor negotiations and debt restructuring for companies in Asia-Pacific. We come with deep investment banking experience and a strong track record across multiple credit cycles in Asia.
20% of Q3 loans are “Cov-lite
Inflation and corporate bonds
Negative yields around the world
High yield issuers lock in rates
Evergrande vs APAC private credit
Benefits of illiquidity
If you have an article on Private Credit that you think is interesting, please send it to us at firstname.lastname@example.org
Source: BlackRock and P&I. Average Private Credit allocations of all plans is a simple average.
Source: Bloomberg Barclays Global Aggregate Negative Yielding Debt Index: Corporates, 29 January 2010 to 9 November 2021, Bloomberg
What was initially a deliberate move by government issuers in Europe and Japan has – as we can see from the right-hand chart – spread to all corners of the public bond market. The restarting of asset purchase schemes by central banks at the onset of the pandemic last year has driven some corporate yields below zero.
… and it’s going to get worse before it gets better
Despite this week’s US inflation news, the Fed continues to stress the need for accommodative monetary policy to boost employment and growth. Rate rises are expected to be gradualist at best because of this – and because vast Fed balance sheet needs to be reduced in an orderly fashion:
Source: FRED Website. Observation as of 12 November 2021.
APAC offers higher IRRs (15% gross, unlevered) than US or European private credit, stronger covenants and structuring and most deals are not PE sponsor-backed. With similar default, LGD and recovery rates to other regions, APAC investors are arguably well-compensated in risk-reward terms for the additional complexity of the region. Deals often include opportunistic, equity-linked, components which may add to upside and diversification in some scenarios.
APAC strategies could play a larger role for the US public pension segment and adjacent institutional investors concerned about how much of their portfolios are being taken up by assets with negative real yields or – through low coupons - are exposed to rising rates and negative convexity.
Source: Preqin as of 31 December 2020
Global Private Credit AUM by Geography
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Total Value of Negative-yielding bonds
APAC Private Credit Return Components
Source: Zerobridge. For illustration only.