Friday HighlightApr 12 2019

Have investors missed the boat in credit?

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Have investors missed the boat in credit?

Does this recent strong performance mean the good times are already over?

We think the case for credit remains strong, but a shift in the backdrop means selectivity and flexibility will be vital for making the most of the asset class.

Boosted by recent tailwinds

After last year’s volatility, credit markets have delivered solid returns so far this year.

Powerful tailwinds sweeping in include a more dovish US Federal Reserve, the increased likelihood of a US-China trade resolution and expectations-beating corporate earnings.

We think the recent market rally is different and that it does not necessarily reflect a wholesale reach for yield.

Supply and demand dynamics have further boosted the backdrop, with net issuance levels subdued but investor inflows strong – attracted by the higher yields credit offers relative to other parts of the fixed income universe. 

Does this strong start to the year mean all the juice has been squeezed out of credit markets, weakening the returns outlook for the rest of the year?

We think the answer is no, but with a few caveats. With the current level of default risk likely to remain low, we believe the credit risk premium continues to offer attractive compensation to investors.

But selectivity and flexibility will be key to harnessing the full potential of the asset class.

Shifting sands

The extraordinary monetary policy that followed the global financial crisis was a positive for credit markets.

In a broad sense, bad news was good news for credit overall, with exceptionally low rates encouraging many investors to explore beyond sovereign debt into the higher yielding part of fixed income markets, pushing yields down and prices up. 

However, we think the recent market rally is different and that it does not necessarily reflect a wholesale reach for yield.

What was once indiscriminate buying has now become more selective, but we believe this selectivity has been largely driven by fear, creating market inefficiencies that nimble and selective investors can seek to exploit in pursuit of compelling risk-adjusted returns.

Where swimming against the tide makes sense

While investors have shown a strong appetite for buying into the recent credit market rally, there is a palpable wariness around certain segments of the market.

Negative headlines around BBB rated credit risk is a notable theme, which has seen many investors steer clear of this higher risk, lower credit quality part of the market.

This is reflected in the meaningful underperformance of the BBB segment. 

The BBB rated credit universe has tripled in size since 2009, as US corporates have taken advantage of cheap financing for M&A and buybacks.

This has helped lift the share of BBB rated bonds in US and European mutual fund portfolios from 20 per cent in 2010 to around 45 per cent last year.

It is understandable why many investors are cautious: if a BBB rated bond gets downgraded it moves from the investment grade category to high yield or ‘junk’ status and with many portfolios restricted to holding only investment grade, the market impact of downgrades can be significant.

With a muted global growth outlook putting increased pressure on issuing companies, investors are right to be cautious.

However, we believe a selective approach to investing in the BBB universe can reap rewards for investors.

We see a significant amount of flexibility in a range of well-run BBB rated companies in terms of the steps they can take to maintain a BBB rating in the event of harder economic times.

Examples include companies like AT&T and Anheuser Busch, which have launched debt-friendly initiatives like reducing share buybacks and — in extreme cases — reduced dividends or disposed of non-core assets.

Many investors have also overlooked corporate hybrid securities – bonds which combine features of debt and equity securities. The expected payoff profile – available upside return versus potential downside risk – of this part of the market is attractive, yet it has lagged year-to-date relative to other areas of the credit market which are perhaps overextended, such as US high yield.

In this vein, dynamism and selectivity are as vital for avoiding the more susceptible areas of the credit market as they are for capturing overlooked potential. 

Swimming against the tide of mainstream investors through a carefully plotted route can bring significant enhancements to both the risk and return side of the equation, in our view.

The benefits of a freestyle approach

An unconstrained investment approach gives credit investors access to a broader opportunity set and affords them greater flexibility to adapt to changes in credit risk premia and market technicals across different areas. 

We believe this approach is best placed to deliver the full risk-adjusted return potential of credit markets in the year ahead.

By increasing the flexibility to seek the best investment opportunities across the global credit universe while avoiding susceptible segments, an unconstrained strategy can provide a diversified portfolio which aims to be high-yielding yet comparatively defensive. 

Investors wishing to navigate the credit world would do well to choose a sturdy yet nimble vehicle rather than hop on the same boat as the rest of the crowd.

Garland Hansmann and Jeff Boswell are managers of the Investec Global Total Return Credit fund