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How should you invest in credit in a low-yield environment?


Sean Markowicz, CFA

Sean Markowicz, CFA

Strategist, Research and Analytics

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Amidst a scarcity of yield in fixed income markets, investors have piled into riskier debt to make up for the shortfall in returns, which may leave them more vulnerable during periods of market stress. However, this does not mean that investors must accept the low yields on fixed income assets. Better portfolio outcomes are possible if given the flexibility to take full advantage of the diversity of credit markets. 

The rich diversity of global credit markets

Credit markets span numerous geographies, sectors and industries. In general, the lower the credit quality, the higher the expected return since investors need to be compensated for the added risk. However, throughout the economic cycle, returns across and within sub-sets of the global credit universe can diverge significantly.

Different markets exhibit non-synchronous behaviour and are prone to short-term dislocations, during which one segment may outperform or underperform for a period of time. It is during these periods that investors can capture potentially higher returns, improve portfolio efficiency and mitigate drawdown, provided they are free to invest and allocate actively. 

It is important to analyse risk-adjusted returns as well. On this measure, which is shown in the figure below, the global passive benchmark scores better (i.e. higher than the median for flexible portfolios) during some periods (e.g. 2000 to 2005) but worse during others (e.g. 2016 to 2019). While the difference is negligible, this also means that flexible investors have, on average, been able to generate consistently higher returns, without an undue increase in risk. These odds could be improved dramatically with any allowance for asset allocation skill, for example by allocating to less risky markets during periods of stress and taking advantage of opportunities when valuations become excessively depressed.

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Not all bonds are created equal

As we approach the end of the economic cycle, a selective approach to credit will be key to protecting portfolio capital. In particular, there are growing concerns about the increasing size of the BBB-rated corporate bond market. Much of this segment could be downgraded to HY when the next downturn occurs. Many investors would be forced to sell these “fallen angels” when they exit their respective IG bond index. However, this tends to be the worst time to do so as it coincides with when credit spreads peak and bond prices trough, resulting in the highest crystallised loss.

Prices typically rebound somewhat after the period of forced selling has ended. As a result, any flexibility to sell before a downgrade or hold on afterwards could result in a better outcome. This flexibility can help investors to mitigate losses during a market drawdown.

Headline yields can be misleading

It is easy to fall into the trap of thinking that as index yields have declined, income opportunities have also evaporated. Yet, the truth is that investors must look beneath the surface to capture higher income potential.

If a bond has a higher yield, it will usually be because the market has a dimmer view of its prospects than the overall market, but not always. Bonds with relatively lower liquidity or a smaller issue size can also make a bond less attractive to some investors and result in a higher yield without a commensurate increase in credit risk.

Fundamental research is key to identifying mispriced bonds and avoiding those that turn out to be cheap for good reason. A selective approach, within a highly diversified portfolio can take advantage of the full range of income options and potentially generate a more satisfactory outcome for investors.

 

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