The surprise Brexit vote rattled markets for a brief period. However, expectations of easy central bank policy—combined with a forceful policy response to limit contagion to other markets—has caused most risk assets to rebound to, and in some cases even surpass, their pre-Brexit levels. For example, the S&P 500 Index1 has crested to an all-time high at the time of this writing, and many credit spreads are back to their tight year-to-date levels.

Even before Brexit, we held the view that slow but steady growth along with supportive monetary policy could turn this credit cycle into the longest in history. Though we think the credit cycle hasn’t turned yet, there has been significant dispersion of returns and fundamentals across various sectors and industries. This is an environment in which sector rotation and active management of credit exposure could add significant value.

Some credit sectors face challenges and others are fundamentally sound

Generally speaking, we believe credit investors need to analyze sectors and companies on two measures:

  • Fundamentals, which include sales, earnings, profit margins, interest coverage,2 EBITDA leverage, cash flows and the associated risks to these measures.
  • Debt valuations, which need to be assessed in historical terms; in relation to debt valuations of industry peers; and in the context of a company’s fundamentals.

These measures are not mutually exclusive. A company may have a great track record of earnings and a promising outlook—but its debt may be overpriced considering its history, business prospects and peers. It doesn’t necessarily mean that the company’s debt is a bad investment, but these are measures that analysts and portfolio managers need to consider.

Here are seven credit sectors we view favorably — and three we’re cautious about:

1. U.S. Structured Credit
What we like… …and why
Asset-backed securities (ABS) collateralized by auto loans
  • These are short-term assets that offer attractive returns and low relative volatility.
  • Rapidly deleveraging collateral and robust structural enhancements allow for ample credit protection under stressed
Agency credit risk transfer securities
  • These securities offer exposure to prime borrowers subject to strict agency underwriting standards at attractive spreads to government debt.
  • While still a relatively new asset class, it is one of the few sources of prime residential credit exposure. The sector is gaining market acceptance through regular issuance, stable deal structures and solid performance to date.
  • They may benefit from improving fundamentals in the residential housing market.
What we’re cautious about… …and why
Asset -backed securities collateralized by student loans
  • They are commonly characterized by high political and regulatory risk, since loan terms are susceptible to legislation.
  • Spreads have been under pressure due to poor fundamentals and ratings downgrades.


2. High Yield Bonds
What we like… …and why
Broadcast media
  • The presidential election year of 2016 is forecast to bring in about 30% higher viewing ratings than the one of 2012.
  • Beside the ratings boost from this year’s election, the 2016 summer Olympics should also provide an attractive source of revenue.
  • Core advertising (which excludes advertising during special, one-off event coverage) continues to grow at least at the pace of gross domestic product (GDP). Television and radio broadcasters are the largest beneficiaries of ad dollars.
  • Even in non-election years, broadcasters manage to generate considerable free cash flow, which is largely used to reduce debt.
  • Fundamentally, television broadcasters are in great shape for all these reasons.
What we’re cautious about… …and why
Retail
  • High yield bond issuers in retail continue to face a number of headwinds—especially in the apparel business—which we estimate will persist for the foreseeable future. (Consumers are spending more of their disposable income on experiences and services rather than on new clothing.)
  • Mall traffic continues to decline for reasons including weather and the increase in online purchases. We expect this trend to continue and create excess seasonal inventory and eventually lower gross margins.
  • We believe that retailers that are too leveraged have very little room for error in their financial management—and one misstep can pose risks to cash flow and liquidity.
  • Demand for higher wages will likely have an impact on operating costs.
  • Additionally, a strong U.S. dollar has negatively affected tourism and sapped retailer traffic.
  • The competitive environment in retail remains exceedingly tight.

3. The International Credit Markets
What we like… …and why
European banks
  • Policymakers and regulators have been accommodative to limit potential contagion and restore confidence in areas slow to recover. Post Brexit, the policymakers were quick to place liquidity facilities in place to limit contagion to the banking system. The upcoming European Banking Authority (EBA) stress test is a catalyst for non-performing loan (NPL) cleanup and recapitalization of some of the weaker banks.
  • From a longer term perspective, the credit fundamentals of banks continued to improve through balance sheet repair and capital replenishment.
  • We expect lower volatility for earnings in the future as regulation has driven banks to adopt business models with more efficient balance sheets and less risky lending. Low rates are a headwind for the banks but improving credit quality and modest lending growth offsets some of the revenue headwinds.
  • Equity capital has been bolstered, provides an additional buffer to absorb losses and improves the position of debt investors.
  • We prefer capital instruments of strong banks with healthy capital buffers above minimum requirements in countries with relatively stronger macro outlooks.
  • We believe that banks still offer investors an attractive entry point after Brexit volatility and confusion around coupon restrictions. Recent comments from European regulators suggest that they are likely to provide more accommodative guidance in the near term and macro shocks from the UK will be manageable in Europe.
European auto manufacturers
  • Pent-up demand and attractive funding terms (driven by low global rates) are favorable factors for the sector.
  • They may benefit from exporting to China, which is the world’s largest auto market. China’s auto sales total 22 million vehicles per annum—and sales are up 6.6% year-to-date.3 We expect growth to remain strong and be reflected in comparison with the sales figures of the summer and fall of 2015.
  • In May, sales for Western Europe’s big five auto markets (Germany, UK, France, Italy and Spain) were up 15.2% year-over-year, and those of all of Western Europe were up 16.9% year-over-year.4 Given extremely low and negative growth rates during the great recession of 2008-2009 and before then, we believe pent-up demand may continue to drive positive results.
Emerging market state-owned oil and gas companies
  • We see a retrenchment in the credit profiles of several state-owned oil and gas companies as new management teams aim to deleverage via asset sales and lower capital spending. Governments are providing support for this adjustment through various means, including capital injections, debt support and the assumption of certain liabilities.
  • Weaker currencies of emerging markets have cushioned the negative effect of lower oil prices on these companies, since their cost base is mostly denominated in local currency.
Emerging market pulp and paper manufacturers
  • Pulp and paper experience lower price volatility than other commodities.
  • As China shifts to a consumer-driven economy, we expect such consumer products to be less susceptible to an economic slowdown.
  • The strength of the U.S. dollar has increased the cost competitiveness of pulp and paper manufacturers in emerging markets.
  • Most companies in the sector concluded large capital-expenditure programs, which bode well for deleveraging trends.
What we’re cautious about… …and why
Emerging market banks
  • A slowdown in emerging market economic growth—as well as weak domestic credit conditions—are leading to an ongoing deterioration in the quality of bank assets in the region.
  • Foreign exchange devaluations represent an additional risk as banks may take loans in one currency while making loans in another.
  • Loan extensions and renegotiations might mask the real levels of non-performing loans.
  • Rating downgrades of emerging market countries (to sub-investment-grade levels, in some cases) are weighing on banks’ bonds, which are closely linked to sovereign issuers.

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1 The S&P 500® Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy the index includes reinvestment of dividends but does not include fees, expenses, or taxes.

2 The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest on outstanding debt.

3 Source: China Association of Automobile Manufacturers, as of May 31, 2016.

4 Source: Statistisches Bundesamt, as of May 31, 2016.