Fitch recently highlighted, in its Mid-Year Sovereign Outlook, that: “There were more sovereign downgrades in 1H20 than any full year prior, and 40 sovereigns are on Negative Outlook, a record high in absolute terms and as a share of the rated portfolio”. The report added: With the number of investment-grade and speculative-grade sovereigns nearly evenly split, and five sovereigns currently rated 'BBB-'/Negative, it is probable sub-investment-grade sovereigns will outnumber investment-grade sovereigns for the first time.” With nearly every nation within the rated portfolio expected to either run higher deficits or smaller surpluses, most nations will suffer fiscal deterioration challenges. However, this is not to say that every rated country will see a downgrade. The rating agency has identified nations such as Singapore and Russia as having strong fiscal positions, while countries including Japan and Bahrain are amongst the weakest. We hold quasi-sovereign positions from the former, with no direct exposure to the identified fiscally weaker nations.
Moreover, Moody’s recently noted that “COVID-19 will likely cause a paradigm shift for key credit risk components and drivers of the global structured finance market, altering the risk profile of many asset classes.” Regular readers will know that at Stratton Street we are value driven, not yield chasers, and often look at the world in a different way from many. We assess our macro models to give us an idea of where we are in the macro economic cycle. Our proprietary Global Growth Model is, as expected, indicating a global recession; although it has ticked up significantly. We have therefore limited the risk profile across our strategies, preferring to hold high-grade sovereign and quasi-sovereign paper, with limited corporate exposure; the largest proportion of corporate exposure is held in AAA and AA rated US corporations such as Microsoft and Apple. Our portfolios therefore have a Single A WARF rating. Many other investors are, however, on the hunt for yield, choosing instead to move down the credit curve and invest in low-grade/junk-bonds. Although we can hold sub-investment grade bonds in our Next Generation strategy funds, we currently don’t as there is little value available in the universe. We do however, hold state-owned PEMEX, which is split rated BBB/Ba2/BB-. If we use the average rating, to calculate the Relative Value of our holdings, we still have significant risk-adjusted expected returns and on average 1-2 notches of credit cushion across our positions.
With the true and long-lasting global economic effect from the Covid-19 breakout still largely unknown, it appears investors face a number of decisions. Amid low interest rates, anaemic growth, long-lasting unemployment and ever-expanding sovereign debt burdens globally, what becomes more important, downside capital protection or a riskier high yielding profile? We know where we’d choose to be positioned.