Tight spreads and investor complacency toward bonds have set up the debt market for a sell-off in 2017, according to Thornburg Investment fixed-income portfolio manager Lon Erickson.
The return on high yield debt and the spreads of investment grade assets hit a low point almost three years ago, Erickson said at a media event Wednesday. But investors have kept spreads tight as they have continued to bet on bonds in search for income amid a low-interest rate environment.
‘Given the amount of rally across markets and spread compression that we’ve had throughout the whole spectrum, as well as regionally, I would say it would [...] be a widespread risk off-type of environment,’ the Citywire A-rated manager said.
In his view, events such as the upcoming French election and the fate of US president Donald Trump’s tax reform plans could trigger a sell off in the next nine to 12 months.
‘The market is very sanguine around these events. The market is not pricing in a lot of volatility,’ he said.
He also added: ‘Given the amount of uncertainty and the seeming level of complacency in the marketplace when you look at measures like volatility I would say that there would be a reasonable shot we get [a buying opportunity].’
Erickson has brought up the cash reserves in his funds up to roughly 10% to seize on the potential opening. Usual cash levels in two funds he runs, the $4.8 billion US domestic Thornberg Limited Term Income Fund and its $1 billion Thornberg Strategic Income Fund range from 3% to 6%.
Erickson has also been sitting on cash because he's not finding compelling opportunities in the current environment. In his view, there’s ‘no bad risk, just bad pricing’.
'We just don't think we’re getting well compensated for that today in this marketplace because there’s been a lot of complacency,' he said.
Erickson has steered the funds he runs into holding less risky assets. The Strategic Income Fund, for example, now holds more BB+ securities than BB- assets.
'That does come with a giveup in terms of yield today,' he said. 'And we're willing to make that trade off because we think we will see the increase in volatility.'
He's also parked money in companies such as food service firm Aramark. The food service sector isn’t prone to sharp volatility during sell offs, he said.
In addition, Erickson continues to hold cable companies such as Virgin Media and Canada-based Vidéotron.
‘Those tend to be good defensive businesses,’ he said. ‘People tend to to downgrade their packages but keep cable around.’
From a geographical perspective, the funds he runs still hold hard-currency Mexican sovereign debt.
He recently bought into a bonds related to a project to build a new airport in Mexico City, though he cut exposure to debt Mexican pesos after the currency rallied against the dollar following the US election.
Brazil, on the other hand, is 'something of a pause button,' he said. Erickson has generally like the country's openness to capital markets, but recently political and corruption scandals have changed his outlook.
In the event of a debt sell-off ranging from 25 basis points in investment grade assets and 75 bps in the high yield space, Erickson would keep betting on ‘generally quality names’ on the BB range.
He’d only venture into CCCs in the event of a sell-off of at least 100 basis points. That opportunity is likely to only arise in a recession, which he doesn’t think is likely for this year.
'It doesn’t feel like we’re in a market fall apart type situation where people are really running for the hills,’ he said.
He added: 'Recession isn't our base case at all, but I would say sometime this year we would get a little bit of opportunity to buy.'
But for now, Erickson isn't making any major bets.
‘At various times our CIO has talked to us and said "did you guys buy anything today?" and we say "no", and he’ll say "good".'