Why the LGPS should consider extended credit
Positioning for the start of the new market cycle is crucial if the LGPS is to deploy risk effectively and maintain long-term funding levels. As we showed in our previous LGPS article, high yield bonds (both public and private markets) and emerging market debt can help local authority schemes to diversify equity risk without undermining long-term expected return. However, with market volatility set to remain elevated, a flexible and active approach will be key to optimising exposure to these extended credit opportunities.
High yield: Capitalise on valuation dispersion
After a very volatile few months, high yield markets now look to offer selected value for the LGPS. High yield bonds sold off dramatically in March as the Covid-19 lockdown hit sentiment, with spreads reaching as high as 9.5% on 31 March. Since then, spreads have narrowed substantially, with yields falling back to 7.4% on 31 May—representing a 60% retracement of the first-quarter sell-off.
Much of this retracement has been supported by government and central bank intervention, with the Federal Reserve’s investment grade corporate bond purchasing programme extended to include fallen angel (bonds that have been downgraded from investment grade to high yield). At current spread levels, high yield bonds appear to be fair-to-tightly priced on average given the expected rise in defaults caused by the economic disruption.
However, the retracement in high yield spreads has not been uniform. The market has received unprecedented inflows from investors keen to participate in the risk rally of May and early June, but these flows have mostly been directed to securities deemed to be the “safest”, outside of those sectors that have been most hard hit by the Covid-19 outbreak—such as energy and leisure.
US high yeld dispersion
This valuation dispersion in the high yield market remains elevated compared to the recent pre-Covid past, creating significant opportunities for discerning investors to exploit pricing anomalies and add value through careful security selection.
Similar divergence between securities that are deemed most able to withstand the downturn and those that are deemed most likely to suffer is also being seen in the private debt markets, creating many attractive opportunities for investors in areas such as distressed debt and special situations.
Investments in private debt have the potential to deliver returns similar to those available from private equity, while boosting portfolio diversification—both by providing exposure to enterprises that are not accessible elsewhere, and by providing access to an alternative set of return drivers.
Emerging market debt: Attractive entry point
Emerging market debt also sold off during the Covid-19 crisis, particularly in local currency and lower quality segments, but has not participated as fully in the subsequent risk rally as high yield in developed economies. This weaker rebound in emerging market debt is largely because emerging markets have not enjoyed similar backing to developed markets from their central banks as “buyer of last resort”.
Nevertheless, as the global economy begins to recover from the pandemic, we see attractive valuation levels across emerging market debt generally. Historically, the 12-month return achieved from current spread levels on emerging market sovereigns has been 10% plus, suggesting that this may be a good entry point for adding a long-term exposure to the asset class.
Emerging market sovereigns: 12-month return from current spread
There has also been a wide dispersion in demand for emerging market debt, similar to the situation in developed market high yield, with investment grade hard currency bonds rebounding strongly while high yield sovereigns and investment grade corporates have lagged. This dispersion in valuations again creates particularly attractive opportunities for investors to identify sectors and securities that present the most long-term value.
Multi-asset credit: Flexibility is key in today’s markets
As the LGPS looks to position portfolios at the beginning of this new market cycle, extended credit sectors appear to offer attractive long-term opportunities to diversify risk without detriment to return. However, with volatility set to remain elevated, an active and flexible approach will be key to extract maximum value from these highly dispersed markets.
In this environment, multi-asset credit strategies can provide an attractive combined credit solution, helping the LGPS to evolve allocations between core investment grade bonds and extended credit sectors, including high octane opportunities in distressed and dislocated debt. These flexible strategies can help ensure that local authorities are able to capitalise on alpha opportunities across the credit spectrum, while also managing downside risk by adapting sector and duration positioning as market conditions change.
If you would like to discuss opportunities in extended credit in more detail, please don’t hesitate to contact your usual J.P. Morgan Asset Management representative.