It is no secret that 2022 has been challenging for fixed income investors. High inflation and the Federal Reserve’s initiation of interest rate hikes have weighed on markets. Nevertheless, the broad credit universe provides ample opportunities for investors to add value through bottom-up research and security selection in each of the four primary credit sectors — high yield, investment grade, emerging markets and securitized debt.
In this article, the first in a series exploring the credit universe, we discuss how income-seeking portfolios can be structured with the aim of adding incremental alpha (excess return) through security selection and asset allocation within a prudent risk management framework.
Among these four credit sectors, capitalizing on relative value can be a very powerful way to enhance returns, especially during periods of high volatility like the one we are experiencing now.
Here are our current views on each sector within credit and where members of our investment team are finding what they believe are attractive return opportunities within the construct of a multi-sector income portfolio.
The high-yield corporate bond market has a long-term record of producing a high level of income, which is the primary contributor to its total return over a full market cycle. The sector is large, at about $1.5 trillion, and spans a multitude of industries and issuers. Investors comfortable with taking on the higher risk associated with high-yield bonds can also choose from a range of bonds of varying quality (secured and unsecured across the BB to CCC ratings spectrum). The high-yield universe also provides significantly shorter duration than investment-grade (IG) corporates and emerging markets debt (EMD).
Unlike equities, where valuations reflect expected future cash flows, high-yield returns are much more a function of an issuer’s current cash flows and ability to service debt. While high-yield spreads can be volatile and directionally correlated with equities, the yield serves to cushion drawdowns and drive attractive total returns over multi-year periods. Spreads refer to the difference in yield between two bonds or types of bonds, which investors use to gauge the valuation of a bond. In fact, it has been quite rare for the high-yield sector to experience prolonged periods of negative total returns.
High-yield returns tend not to stay negative for long
A large part of the sector is reasonably liquid, allowing for fundamental research to guide relative value decisions by moving between securities from different parts of a company’s capital structure, within an industry or across the high-yield sector. That said, we have recently reduced our allocation to high yield, to well below our neutral allocation, as we believe its relative value has declined compared to emerging markets, securitized credit and investment grade.
Over multiple decades, the relationship between high-yield and investment-grade spreads has followed a similar pattern. High-yield spreads tend to widen significantly compared to investment grade during crises and periods of weak economic growth. Historical spread relationships act as a guide for when high yield becomes more attractive than investment grade during periods of stress. Outside of those crisis and recession periods, spread relationships are much more stable and generally hover within a predictable range. In the current environment, we expect that slowing economic growth will continue to push high-yield spreads wider compared to investment grade. As such, we are monitoring valuations and the economic backdrop and will increase our holdings given the right windows of opportunity.
High-yield vs. investment-grade spreads appear tight
Securitized credit can provide a higher level of income than investment-grade corporate bonds with comparable ratings, while offering similar downside protection. The sector offers diverse investment opportunities across asset-backed, commercial real estate, non-agency mortgage and collateralized leveraged loan sub-sectors. Many of the fundamental drivers of these sectors are distinct from corporate and sovereign credit. This brings diversity to the portfolio. The sector is also under-researched by many market participants, enabling our team of securitized credit analysts to identify numerous mispriced investment opportunities.
Securitized credit has relatively lower liquidity. As a result, repricings happen with a lag, compared to more liquid credit sectors, such as corporates and emerging markets debt. For example, when corporate spreads widened earlier in the year, especially after Russia invaded Ukraine, securitized credit initially did not move as dramatically. Spreads on securitized debt started to widen in March, at which point corporates had begun rallying back. This created a relative cheapening of securitized credit, which presented a good opportunity for investors. We added to asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), and took some small positions in collateralized loan obligations (CLOs), which were attractive relative to comparably rated investment-grade corporate bonds.
We are currently finding good value in the single-asset single-borrower (SASB) market. These niche investments create more concentrated risks than traditional CMBS, but the market largely consists of very high quality properties and lends itself to deep, property-specific fundamental research. This presents an opportunity for investors to gain access to specific assets that they find attractive.
Elsewhere in securitized credit, we are seeing good value compared to investment-grade corporates in AAA-rated tranches of several sectors: subprime auto, single-family rental and private student loans. In each case, the strong jobs market and high cash balances provide strong support for the consumer making payments on underlying loans.
Spreads between CMBS and corporates remain wide
EMD offers investors a high level of income and total return. The investable universe for emerging markets debt includes both investment-grade and below investment sovereign and corporate debt, which allows for broad relative value comparisons within the sector and across similarly rated investment-grade and below investment-grade corporate and securitized debt.
EMD valuations, especially those of below investment-grade-rated securities, have remained cheap relative to high-yield corporates following the March 2020 selloff. More recently, rising inflation, slowing global growth, tightening U.S. monetary policy and a soaring U.S. dollar have all weighed on the sector. The Russia-Ukraine conflict has created an additional headwind relative to other comparably rated developed market corporate debt.
But there is reason to be optimistic about the future of emerging markets. Indeed, many emerging markets central banks are well ahead of the Fed in terms of hiking rates to rein in demand in their economies to try to tame inflation. As emerging markets economies tend to be smaller, less economically diverse, and more reliant on exports and imports, inflation is a much more prevalent issue in these markets. Where developed markets are scrambling to address inflation that hasn't been seen in many decades, many emerging markets have an established playbook for how to rein in inflation domestically. Additionally, while higher energy prices are a challenge and many EM countries face food security problems as a result of the Russia-Ukraine conflict, numerous emerging markets (especially in Latin America and parts of Africa) are net beneficiaries of higher commodity prices since they are net exporters. Therefore, we believe that, at current valuations, EMD compensates investors well for the risks they face from what we believe should be a manageable situation.
At today’s starting yields, EMD forward returns have historically been attractive
Investment-grade corporate bonds make up the largest sector in the credit universe. It is well-diversified across issuers and industries, and includes securities with maturities across the yield curve. We specifically like how the sector can be accretive to a portfolio’s overall yield, in addition to being less volatile than high yield as a result of tighter relative spread movements.
Investment-grade corporates tend to be longer duration and lower coupon than high yield. This makes the sector more sensitive to interest rate movements. That said, because it is higher quality, spreads tend to widen much less relative to high yield when the economy slows and fundamentals weaken.
Until recently, our asset allocation process led us to hold a very small position in investment-grade corporates, as we found more value in emerging market debt, securitized credit and high-yield corporates. Following the March 2020 selloff, investment-grade spreads compressed toward historically tight levels, while issuance remained at record volumes. Against the backdrop of stronger value in other sectors, we saw the relative value in investment grade to be less attractive and our investment-grade holdings were near historically low levels.
With the recent selloff related to higher inflation and interest rates, as well as concerns about a slowing economy, we have been incrementally and modestly increasing our exposure to U.S. investment grade. Specifically, we have found value in certain financial services, health care and media issuers. That said, we remain underweight investment-grade debt overall. We have the flexibility to further increase exposure or decrease as the near- to medium-term outlook for the global economy remains uncertain.
In summary, all four sectors of the credit universe play an important role in income-seeking portfolios. The high income of the high-yield and emerging markets debt sectors are balanced by the defensiveness of the higher quality investment-grade corporates and securitized sectors. The shorter duration of high-yield and securitized credit temper the higher interest rate sensitivity of the investment-grade and EMD sectors. Overall, credit spread correlations (or the tendency for spreads on different securities within a portfolio to move in a similar fashion) are reduced by the inclusion of securitized and sovereign credit. These sectors offer fundamental drivers that can be distinct from the corporate credit drivers in high-yield and investment-grade corporates.
Given the uncertain economic environment, we believe taking a diversified, balanced approach to credit is more important than ever. We currently favor securitized credit, followed by emerging markets debt, and are taking a somewhat cautious approach with our investments in high-yield and investment-grade corporates.
The J.P. Morgan Emerging Market Bond Index (EMBI) Global Diversified is a uniquely weighted emerging market debt benchmark that tracks total returns for U.S. dollar-denominated bonds issued by emerging market sovereign and quasi-sovereign entities. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of account fees, expenses or U.S. federal income taxes.
J.P. Morgan Government Bond Index — Emerging Markets (GBI-EM) Global Diversified covers the universe of regularly traded, liquid fixed-rate, domestic currency emerging market government bonds to which international investors can gain exposure. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of account fees, expenses or U.S. federal income taxes.
Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index covers the universe of fixed-rate, non-investment-grade debt. The index limits the maximum exposure of any one issuer to 2%.
Bloomberg U.S. Corporate Investment Grade Index represents the universe of investment-grade, publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity and quality requirements.
The Bloomberg Global Investment Grade Corporate Bond Index is a rules-based, market-value-weighted index engineered to measure the investment-grade, fixed rate global corporate bond market.
The Bloomberg Global High Yield Index is a multi-currency flagship measure of the global high yield debt market. The index represents the union of the US High Yield, the Pan-European High Yield, and Emerging Markets (EM) Hard Currency High Yield Indices.
The Bloomberg CMBS ex AAA Index tracks investment-grade (Baa3/BBB- or higher, excluding Aaa/AAA) commercial mortgage-backed securities that are included in the Bloomberg U.S. Aggregate Index.
The Bloomberg Baa Corporate Index measures the Baa/BBB-rated, fixed rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.
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