Paul Wiseman, Senior Investment Analyst in London, discusses how following the Global Financial Crisis, many investors believed that credit ratings issued by the ratings agencies should be treated with some scepticism. He believes that whatever your view, the credit ratings still exist and remain a relevant consideration for many fixed-income mandates.
Most credit indices have eligibility criteria and rules that are governed by the ratings of one or more ratings agency. While many may not trust a credit rating as the true reflection of a borrower’s creditworthiness, they are hard to ignore as, in aggregate, they define whole segments of the credit market. Specifically, we refer to the distinction between investment grade (AAA to BBB) and high yield credit (BB and below).
During the first half of 2018, US investment grade credit underperformed the high yield market by some margin. As US Treasury yields rose during this period, we would fully expect investment grade to underperform, due to the higher duration (interest rate sensitivity) of aggregate investment grade indices relative to high yield. Our focus when analysing credit is therefore typically on spreads, rather than the all-in yields.
What we witnessed during this first half was a fairly significant compression of high yield spreads over their investment grade counterparts. The relative spread moves between investment grade and high yield struck us as interesting and prompted us to look below the index level. What we found was a large degree of bifurcation across the ratings spectrum. Lower rated segments (B, CCC and below) of the high yield market were the best performers while higher rated high yield spreads (BB) and lower rated investment grade spreads (BBB) had performed poorly. This is shown in figure 1 below.
Figure 1: 2018 credit spread moves (in basis points)
Source: Maitland, ICE BofAML data
What contributed to the credit spread moves?
Our research suggested a number of factors had contributed to this dynamic:
- The ratings composition of aggregate investment grade indices has declined over the past decade, with BBB rated issues accounting for just under half of the index. The composition of aggregate high yield indices is marginally changed over the same period. As the credit cycle becomes more mature, the market may be re-pricing the deterioration in aggregate credit quality. For example, the aggregate exposure of BBB rated bonds in the Bloomberg Barclays US Investment Grade Corporate Index is larger than the entire US high yield market.
- Trade tensions, political uncertainty and emerging market instability have impacted more globally orientated businesses.
- In contrast, US high yield issuers are typically more domestically focused firms and generate a greater share of their total revenues from the US. This has meant that many US high yield issuers have been protected to some extent from the volatility associated with the Italian political turmoil that impacted markets in May and June, as well as ongoing trade tensions between the US and China. Given that approximately 15% of the US high yield market is made up of energy related issuers, the rise in the oil price during the first half of the year has been a tailwind for corporates in the energy sector.
- Issuance in the investment grade market (particularly by BBB rated issuers) was strong during the first half of the year while the high yield market benefitted from reduced supply. It may also be the case that high yield issuers have instead turned to the leveraged loan market to raise capital.
- Reduced foreign buying of US fixed income assets may have also contributed to reduced demand at a time when supply has increased.
- All-in yields for high yield credit look attractive to domestic US investors. As US Treasury yields have increased, the all-in yield on lower rated credit assets looks to be more attractive relative to Treasuries or higher rated credit assets.
- US tax reform contributed to a widening of investment grade spreads as US corporates liquidated short duration investment grade portfolios in order to repatriate foreign profits (which corporate treasurers had invested in short-duration corporate bonds). In addition, the introduction of the base erosion and anti-abuse tax (“BEAT”) saw the US branches and subsidiaries of foreign banks change the mechanics of their funding structures in order to optimise corporate funding. These effects were similar to what we saw during the US money market reform in 2016.
Our starting point is always valuation
We would argue that much of the compression between investment grade and high yield spreads during the first half of the half of the year was technical in nature, rather than being driven by fundamentals.
While technical factors can act as headwinds or tailwinds to any asset class, they are never the sole reason for our investment decisions. Rather, our natural starting point is always valuation – what we are paying for an asset (or asset class) relative to the underlying fundamentals and the potential risks. Throughout 2018, we have been of the view that while defaults are likely to remain benign, high yield spreads were too tight and did not offer sufficient value relative to underlying risks and fundamentals. As a result, we have not carried any dedicated exposure in our portfolios even as the asset class outperformed during the first half of the year.
Fast-forward to today, where volatility across asset classes has increased sharply since the start of October. US corporate credit has held up fairly well but we have seen a reversal of the dynamics we witnessed during the first half of the year – a decompression between investment grade and high yield spreads. Referring again to figure 1, we can see that this decompression was led by the lower rated, high yield segments and the higher rated investment grade segments.
We think that these recent moves have been largely driven by fundamentals. Even after the accelerated, relative weakness in high yield spreads, we still believe high yield credit looks expensive and does not adequately compensate investors for late cycle risks. As we do not invest in the rear-view mirror and need to have a view of how to invest going forward, we continue to avoid dedicated high yield exposure in our portfolios on account of current valuations, even if this means forgoing the potential for further outperformance.
Don’t dismiss high yield credit altogether
Does that mean we should dismiss high yield credit in its entirety? Not quite. While we are avoiding generic or direct allocations to the asset class as whole, high yield credit plays an important role in the construction of a diversified credit portfolio.
Our focus is on the selection of active managers that have the ability to gain selective exposure to high yield credit in their investment grade or multi-asset credit portfolios. Active managers are able to select high conviction high yield securities to supplement the overall yields of their investment grade portfolios, especially those with shorter maturities. This is particularly the case in Europe at the moment, where European high yields spreads are trading wider than their US counterparts. In addition, for US dollar investors, hedging Euro denominated credits back into US dollars results in healthy yield pick-up as a result of the favourable interest rate differential.
Don’t ignore the BBB rated segment either
As we noted above, the BBB rated segment has performed poorly during the year. A commonly cited concern associated with the aggregate investment grade market is that of the large concentration of BBB rated bonds. We noted above that these bonds account for just under half of the US corporate investment grade index and are larger than the entire high yield; in fact, 1.3x larger by market value. This is something we clearly cannot ignore. However, as we know all too well, not all BBB rated bonds are created equal and there are clear pockets of opportunity and vulnerability as the fundamental backdrop is quite varied. This is likely to create dispersion in returns across sectors and issuers. Therein lies our belief that active management is worth pursuing in the credit market. While the potential for downgrade risk certainly exists, we do not think this is an imminent risk. Dismissing an entire segment of the market based on the potential for a wave of downgrades to high yield status is naïve as this necessarily dismisses the attractive opportunities that are still housed under the BBB banner. Again, this is something we look to counter by investing with active managers who are able to assess the risks and opportunities in this segment of the market in great detail.
Favour a defensive stance
So where does that leave our view on US corporate credit? In short, a more nuanced approach is most appropriate to us. We would favour a more defensive or ‘up-in-quality’ stance in our active fixed income exposures. This means favouring direct investment grade exposure over high yield credit and moving up the quality spectrum within our investment grade exposures. Investors should focus exposures on higher rated credits, on average, even if this means sacrificing some yield in the process. We believe this to be more prudent at the current stage of the cycle, rather than trying to chase returns.
In addition, we would focus on shorter duration investment grade assets (in US dollars) given current spread levels and the steepness in the short and intermediate maturity sectors of the underlying US Treasury curve. With two-year US Treasury yields at their highest level since 2008, the Fed’s actions and forward guidance have already done a lot of the hard work for investors in increasing the interest rate component of all-in yields to levels that can’t be ignored. While the economic cycle may indeed have further to run, chasing yields and returns may not end well for investors when the cycle finally turns. Fortunately, being defensively positioned in the interim offers investors an attractive place to wait.