Our strong belief that we are at a cyclical top in credit is reinforced by what we are seeing in the high yield market, where we manage portfolios in other strategies. Typically, it is in the high-yield market that warning signs first manifest themselves of egregious bullishness, and at present we would point to a number of red flags, including record low credit spreads, the emergence of increasingly leveraged businesses, issuance of bonds with weak covenants, and companies raising large amounts of debt to pay dividends to shareholders.
Source: JP Morgan, as at 31/3/21
Source: Bank of America, as at 22/4/21
Issuance of low-quality CCC-rated high-yield bonds so far in 2021 relative to previous levels, combined with a sharp decline in yields are signs to watch, potentially suggesting that this area of the market is already richly priced amid high investor risk appetite. Could potential trouble here make its presence felt further up the credit-quality spectrum?
To us, these realities all point towards sentiment being stretched to the upside. Meanwhile, if sentiment reverses sharply in the high-yield market, the effects can quickly ripple up through the credit-quality spectrum into investment grade.
Risk and opportunity: a delicate balance
This begs an obvious question: what is the appropriate response to stretched valuations in terms of allocations to investment-grade credit? Simply put, current tight spreads do not scare us, for the simple reason that we believe a pragmatic, active and risk-aware approach to portfolio management allows us to be well prepared for what we see as the inevitable turning of the credit cycle, and to capitalise on subsequent opportunities. Conversely, we believe there is good reason to believe that an eventual rotation in sentiment could cause significant challenges for those portfolios with a less active approach and/or consistently higher risk allocation.
At the time of writing, we hold more than 22% of the portfolio in ultra-high-quality AAA-rated corporate bonds, around 6% in Gilts, and have a modest allocation to cash which should enable us to cushion our investors from the worst effects of any negative shift in market sentiment, while providing us with the ability to rotate from this defensive ballast into riskier assets once any spread widening has occurred.
At the same time, it is important to emphasise that this is not a homogeneous asset class; as such, the detailed research work the team undertakes is enabling us to maintain exposure to credit risk in those areas where we believe there is still upside potential, such as in bonds issued by airport owners.