While there are signs of overheating in credit markets there are still opportunities to be found, even when central banks are lifting rates, according to the global fixed income team at T. Rowe Price.
The manager said an overall tightening of financial conditions had a knock-on effect on emerging markets (EM), where several central banks had taken action in response to a combination of depreciating currencies and domestic inflation pressure.
In June, Mexico, Turkey, India, the Philippines, the Czech Republic, and Indonesia all raised interest rates, and it is likely that more EM countries will follow in the second half of the year.
“This is a challenging environment for fixed income investors,” said Arif Husain, portfolio manager and head of international fixed income at T. Rowe Price. “But opportunities can still be found even when central banks are hiking.”
Signs of overheating in credit markets were apparent in the recent pick up in merger and acquisition activity, with 2018 looking set to be a record year in the U.S. for acquisitions.
“This has occurred at a time when fears of an overhang from issuance and excessive valuations have weighed on prices in investment-grade corporate bonds,” Husain said.
“Investors’ appetite for corporate bonds has clearly waned lately, as shown by the concessions given on new issues.”
Husain said there may be an opportunity to switch some credit risk out of corporate bonds into agency mortgages, where signs of overheating have been far more subdued.
“Although home prices in the U.S. have steadily outpaced income growth for the past two years, the situation remains relatively healthy, with data indicating that the average household debt service ratio is at its lowest since the financial crisis,” he said.
“The shape of the interest rate swap curve makes owning a combination of agency mortgages with higher coupons and lower durations a very attractive proposition offering better risk/reward compared with investment-grade corporate bonds.”
