Have investors missed the boat in credit?

Written By: Jeff Boswell Head of Developed Market Credit Investec Asset Management

& Garland Hansmann Portfolio Manager Investec Asset Management

Jeff Boswell and Garland Hansmann of Investec Asset Management survey the pros and cons of the credit market and look at how investors can adapt to access its full risk-adjusted returns potential

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 and expectations-beating corporate earnings. 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. Perhaps some caution is warranted as volatility returned to credit in May, with the prospects of a US-China trade resolution looking less certain and global growth starting to soften.

Does the 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% in 2010 to around 45% 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 vs. 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.

Investments carry the risk of capital loss.

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