Understanding risk and reward in bond markets

1. Are default rates unusually high at present; how do you think about exposure to credit risk in the current market?

With default rates around historic lows, it’s impossible to deny that we are due a pick-up in defaults. But before we panic, we need to consider a couple of things.

Firstly, the quality of the high yield index has been improving. Whereas BB credits – those just under investment grade – used to make up around 35% of the index, they make up close to 60% today. More interestingly, BB- and B-rated bonds have seen their respective default rates declining over the last 30 years. This was supported by an accommodative monetary policy which facilitated company financing.

There is an argument to be made that given elevated inflation, central banks will have less appetite to pacify risk markets through quantitative easing. Instead, we have seen a rise in fiscal intervention to support the economy. We only have to look to the pandemic or the cost-of living crisis that we are experiencing now to see the extraordinary measures that governments around the world are taking to support the economy.

We expect default rates to rise from their current floor but with companies broadly in better shape than they were two decades ago and with governments’ willingness to resort to unconventional measures to prop up the wider economy, we don’t expect a meaningfully worse default cycle. Current valuations are reflecting a lot of negative sentiment, but we think we are being compensated for the risk.

2. How is credit risk measured by the market and how does it differ in different areas of the bond market?

Risk in fixed income markets is largely made up of interest rate risk and credit risk. Interest rate risk (duration) is largely concerned with government bonds (risk-free rates). If you buy gilts for example, you are effectively lending to the UK government which is considered risk-free.

If you buy a corporate bond (a bond issued by a company, rather than the government), there is theoretically a higher risk of default and investors would want to be compensated for that. This extra risk (and compensation) for investing in a company rather than a government is what we refer to as credit risk.

High quality companies (investment grade companies) which have a lower rate of default would have lower credit risk than a high yield company (lower rated by the credit rating agencies). 

3. How is the yield on a bond influenced by credit risk?

The riskier the company, the more likely it is not able to make payments on its coupons or worse, go into default. As bonds issued from these companies have more risk, an investor would demand a higher rate of return for lending to such a company. A higher required rate of return means that the yield on a bond issued by a riskier company would be higher than the yield of a bond issued by a lower risk company.

4. How can one mitigate duration risk in a portfolio? 

Long-dated bonds have the highest sensitivity to a change in interest rates, and so to mitigate duration risk, an investor would want to avoid longer-dated bonds.

5. How can you take advantage of market inefficiencies?

Markets are inefficient and active investors can take advantage of discrepancies. We often do what we call ‘relative value’ switches between bonds issued by the same company in different currencies or at different levels of the capital structure.

For example, a UK domiciled company could issue bonds in US dollars as well as sterling. At various times the US dollar bonds might underperform and so look more attractive than the sterling bonds. As active investors we would take advantage of the relative cheapness of the US bonds and buy them.

Similarly, when we are analysing a company as a potential investment, we look at its ‘capital structure’ (its different tiers of debt, with their different levels of risk). At times the higher risk (subordinated) bonds might underperform and so we would switch into higher quality bonds issues by the same company. The key to managing risk is to remain active.

6. Where are you finding opportunities in bond markets right now? 

Quantitative easing has been a tide that has lifted all boats for the last decade and with a reversal of this, I expect that there will be much greater dispersion and volatility in bond markets, which is a boon for active investors. We see bond markets behaving irrationally frequently, and increased volatility and dispersion only increases the opportunity set for active investors to take advantage of.

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Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness.

Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice.

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