Where to find credit when credit is due?
As the economy continues to recover, and corporate yields start to rise in spite of a Federal Reserve (Fed) on hold, many investors are focusing on their credit allocation. Specifically, investors are examining their high grade to high yield asset allocations in search of the best risk/return profile for this environment. Investors remember all too well the painful drawdowns experienced at the beginning of the Covid-19 pandemic in March 2020, many spent the latter half of the year trying to recover from those drawdowns as well as considering how to shift their credit allocation to protect in a downturn. Now that the credit market has entered a recovery cycle, investors are looking towards yields and returns and how to navigate capturing the upside while avoiding the downside of credit markets.
Where in the market can investors turn to find attractive risk-adjusted value?
To take advantage of the return potential of today’s environment, we believe opportunities exist in the higher beta parts of the credit spectrum, where duration is less of a concern. Looking to the future, the ability to be nimble through a cycle across the full credit spectrum provides greater potential for better risk-adjusted returns over time.
Within the high yield space, we are seeing improving corporate fundamentals, coupled with a default rate that peaked in late 2020. The overall quality of the market has improved, with a lower implied default rate and a lower percentage of distressed bonds in the high yield index. Additionally, high yield bonds typically offer a greater spread buffer than higher quality investment grade bonds, which can help offset the negative pricing impact of rising rates. While the market is starting to price in the substantial improvements in fundamentals, we believe there is still value to be captured.
Loans are another interesting part of the credit market. We consider loans as complementary to high yield; while the profile of the loans space has become a riskier market with lower quality and the changing composition of borrowers, we still prefer loans as they give us the opportunity to invest across the capital structure of high yield companies without taking on the associated interest rate risk. There is also a correlation between loan inflows and rising treasury yields; coupling that with the high demand we have seen for CLOs year to date, and loans should benefit from improving technicals and can offer attractive carry and lower interest rate risk.
Similarly, when thinking about capital structure, we continue to see value by tactically shifting from senior bank debt down to subordinated bank debt. Due to the strong balance sheets of banks that resulted from regulation post-Great Financial Crisis, down-in-capital structure securities are trading at an attractive relative value, though it is important to have the necessary expertise to understand the nuanced structures in the space. European banks in particular have remained well-capitalized and meeting regulatory buffer requirements through the pandemic – with this context, senior bank debt is trading at very tight levels, contrasting to its appealing AT1 counterpart.
Emerging market corporates are also seeing strong earnings recovery that should lead an improvement in overall credit metrics. We’ve already started to see ratings recover at a measured pace, and default rates are relatively low. This is another area of the market that can be navigated tactically to add value when opportunities arise. However, there are some areas that may warrant more caution, so investors should be selective by region and issuer.
As discussed, generally higher quality parts of the market don’t look as attractive as investment grade corporates are trading generally at very tight spread levels (i.e. senior bank debt). Investors looking for opportunities may migrate down in credit quality, looking for value in the crossover space. For example, rising star candidates that are expected to be upgraded to investment grade in the near term are approaching levels that are similar to the BBB peers. However, other candidates that are expected to take longer to be upgraded can still offer some opportunity. When rotating down in quality, investors must always exercise caution to balance the higher return potential of the securities with the higher risk profile.
 ICE BofA US High Yield Constrained Index (USD)
Listen to our audio podcast on how pensions are approaching multi-sector credit portfolios.