The Investment Conversation: A Short Guide to Short Credit
PODCAST – Short-Duration Strategies
The Investment Conversation: A Short Guide to Short Credit
VO: Welcome to The Investment Conversation, Lord Abbett’s ongoing podcast series.
Will Andrews: this is Will Andrews, digital content editor for LordAbbett.com. Joining me today is Lord Abbett investment strategist, Joseph Graham. Joe, you and your team have produced a series of white papers on short duration credit, covering some of its key aspects, its longer-term performance, historical roles, a hedge against interest rate risk, and its application for strategic cash management. This is all intriguing stuff, but first let's define the terms here. What do you mean when you talk about short duration credit or short duration?
Joseph Graham: Sure, Will. So, usually what's used is the one to three-year corporate index, either the [ICE BofA] Merrill Lynch or [Bloomberg] Barclays. That's the traditional benchmark. Really, a better benchmark (and we'll discuss the reasons why) is probably the [Bloomberg Barclays] Universal, under three years. And that's because just it is that, it's universal. It encompasses many different asset classes.
We're generally interested in the credit sensitive portion--that has a bit of ambiguity in pricing, of course, [and thus] creates that active opportunity. The Universal, includes IG [investment grade] and high-yield corporates. That's the most common thing that people think of.
But also ABS [asset-backed securities], which for us is pretty broad. We use securitized portfolios backed by credit cards, by autos, by leveraged loans, which are called CLOs [collateralized loan obligations], some equipment financing, student loans, [and] other consumer loans. And then CMBS is another big category.
Andrews: And that's commercial mortgage-backed securities, right?
Graham: Right. And there are really two big sectors of that market, the single-asset, single-borrower market, and what you would call the conduit market, which is made up of different kinds of securities or different kinds of mortgage-backed securities, all in one deal. So those are the major areas, along with some mortgages. The mortgages tend to be longer-dated, and we're talking about short duration here. So that isn't as important.
Andrews: The first paper in your series gave us an overview of short credit. We've seen some volatility in fixed income over the past few decades. And in that respect short credit has a track record that might surprise some people. Can you walk us through the performance, and maybe give us some reasons why it has performed the way that it has over the past few decades?
Graham: I think this is a really interesting part of the short duration space. You see a few studies that are published on this every couple of years, but it's really not that commonly known, that if you look at portfolios of bonds that are grouped by term risk—from the most term risk down to the least term risk - if you were to look at a chart [plotted] by Sharpe ratio, that as you reduce term risk those bonds have higher and higher Sharpe ratios.
Andrews: Sharpe ratio, just for some of the listeners, is risk-adjusted return?
Graham: Exactly, right. So as you walk down in risk, you're getting higher risk-adjusted returns, which on the very surface may not seem that surprising since you're taking less risk. But it is actually kind of surprising because what modern portfolio theory tells you is that if something has more return per unit of risk, some money should flow into that space essentially.
So what you should see happen is that money should flow into short-term bonds, maybe on a levered basis, in order to correct that arbitrage between short-term bonds and long-term bonds. But you haven't seen that.
And there are a number of reasons why we believe you haven't seen it. Probably prominent among those reasons is the amount of restrictions that occur in the short-term space - investor policy statements are written in such a way that [portfolios] often can't dip down in credit quality, or they can't utilize certain instruments. So, that's a big thing.
What we also think is happening is very similar to the low-beta phenomenon in equities. And people don't often relate those two things, but I think they are related. Because if you look at the body of literature around low beta and equities, what you find is that there are a lot of explanations that have to do with what we call lottery stocks, this idea that investors over-prefer things with binary outcomes or very volatile outcomes.
Andrews: Like people are always looking for those “unicorns” in the stock market.
Graham: That's right, and it's actually somewhat rational because they're investing their time and effort researching an idea, a theme, what have you. They need to get paid for that time, so they want to find something that's directly related to what they just researched, not something that's sort of related to what they just researched. So [investors] tend to go for high volatility things, but they do so in a way that's noneconomic, because they over-prefer them, and so the volatility of those [securities] is high and the returns are actually pretty low relative to their low-beta counterpoints.
Now, what isn't often talked about is that exact same thing happens in credit. So as people do credit research, it's the same concept. Research on a theme, an idea—they want something with a lot of spread duration. That's a function of time. So, [investors] often go after things with lots of spread duration that are usually longer-term instruments.
Andrews: So, they're looking for home runs versus singles or doubles?
Graham: Right. And again, it's rational. It's not very easy to do credit research for something that matures in nine months. It's just not often done. It's usually a different department of a bank, or an asset manager, not usually their credit people, for obvious reasons. It's just very labor-intensive, there's a lot of turnover. So we think all those reasons are why the short duration anomaly exists. And just to be clear, [that refers to research that shows] that short duration credit outperforms longer duration credit, in a risk-adjusted way.
And I also think, importantly, none of those reasons have specifically to do with corporate [bonds] though often you'll see a lot of the research is on corporates. We've done a lot of research that encompasses ABS, CMBS, all these asset classes I mentioned, and you find the same anomaly in those asset classes. And that stands to reason, right? Because if it's hard to do research on corporates it's probably pretty hard to do research on asset-backed securities, [the particulars of which] can sometimes be pretty esoteric.
Andrews: We've been discussing duration here, [which is] the topic of another paper in the series. When we talk about a portfolio and its sensitivity to interest rate changes-- what are some of the characteristics of short credit that that make it an effective diversifier, especially when we consider interest rate risk?
Graham: Well, the most obvious is duration. So, if your duration is down, by definition, your exposure to interest rates is less. That's pretty straightforward. What I think is not straightforward is a couple of other things: Just how much interest rate exposure is in investor portfolios that they may or may not be aware of? Core fixed income portfolios, the bedrock of many investor portfolios, are really all about one risk, and that's interest rate risk.
If you look at a breakdown of risk--where does standard deviation come from-- which is something we often talk to investors about, what you see is that more than all of the risk comes from curve risk. So just to use the Barclays Agg [Bloomberg Barclays U.S. Aggregate Bond Index] as an example, there's roughly in the high 70s basis points of standard deviation per month. More than 80 basis points of standard deviation comes from curve risk.
The rest of the risks that are in the Barclays Agg, things like volatility, or credit spread, or credit default, they're either nonexistent or they're actually diversifying risk. So that's the first major point: if you have core fixed income in your portfolio, chances are you have one big risk in your portfolio, and that's interest rate risk.
The second thing is how credit performs when duration does poorly. So I think that's often not appreciated by investors. If you think of a scenario where duration is hurting you—and you don't have to think very far back because that happened this year—where interest rates are rising, what typically happens during that scenario is that interest rates are rising because the economy's improving, because growth is solid.
Credit usually does well in that scenario, so there's a nice natural yin and yang to those two things that diversifies [fixed-income portfolios]. So, for all those reasons, I think [that] in a rising interest rate environment, credit, and especially short credit portfolios, can be a very nice and often overlooked diversifier.
Andrews: The most recent paper in your series focuses on opportunities in strategic cash, something where people are typically totally risk-averse. So, they may not understand the role that short credit could actually play in a cash management scenario. Can you give us some insights on that?
Graham: That's right. The key of that paper is that if you look at a credit spread and you break down, "What is that? What is that actually paying you for?" it's actually different at different lengths and at different qualities. And by lengths I mean maturities. So if you're looking at investment-grade bonds, whether they be corporates or something else that are typically shorter in duration, what you'll find is that for credit spread, very, very small portions of it are actually default risk, or risk of loss of principal.
And the reason for that is something called the term structure of default, so if I rate something highly right now and then look out a year or two years, chances are that's not enough time for something to really go wrong. If it's investment grade, it's [widely considered] a rock-solid credit. Things don't devolve that quickly; it takes a while. And that's the term structure of default, that if you look five, six, seven years out, yes, then things can go wrong. Different things can happen to either the [issuing] company or the security.
So what that means is you're getting paid for something else, not [the likelihood of] default. And those things, typically, [are] liquidity and non-diversifiability. Let me explain those a little bit. Liquidity is just that it's a spread to U.S. Treasuries, and Treasuries are typically more liquid, especially in bad times, where Treasuries become liquid and things like corporates become less liquid.
Andrews: They become a haven.
Graham: That's right. It's tough to disentangle. It has to do with the second thing, which is non-diversifiability, which is when corporate bonds go bad that tends to be when everything else in your portfolio goes bad. And so that's a negative feature. It's not a great diversifier in that respect.
And so those are the two things you're being paid for with an IG short credit spread. Now, back to your original question. How can cash managers utilize that—do they care about those two things? Do they care about liquidity? Well, sometimes they don't because their holding period can approach the weighted average life of the portfolio, meaning they have the ability to hold to term. So, liquidity isn't that important for somebody with the ability to hold to term.
Secondly, diversifiability. Think about what these portfolios are when they're medium-term cash portfolios, or short to medium term. And I'm talking about a year, or something around there. Are those portfolios composed of a blend of equities, and fixed income, and other things? No. They're typically fixed-income portfolios. So do you care how much they diversify you from equities, or are they standalone portfolios that are meant to match liabilities?
More often, we find that they are those things. So that's kind of an arbitrage for people. It's not a true arbitrage, but it's something where your risk preferences are that you don't care about those two things, and yet you're getting paid for them. So in our opinion, that's something people should do. They should match up their liabilities with their holding periods, and that means that short credit portfolios are appropriate for a lot of investors.
Andrews: What value can a manager add in this situation?
Graham: If you look at things like S&P's data on how managers outperform it's really interesting. So often that data gets brought up to paint equity managers with a bad brush and say, "Well, the equity managers that outperform aren't the same equity managers that outperform in other periods."
What's interesting though is if you dig into that data and looked at fixed income managers—and I'm specifically talking about short- and intermediate-term managers—if you look at what they call non-overlapping three-year period, a three-year period where there's a top quartile manager, what is their probability of being a top quartile manager in the next three-year period? It is far above randomness; it's something like 40% instead of what you would expect, at 25%.
And why is that? That is because we think those managers have good credit processes. They're able to pick and follow credits, they're able to lean on credit. Sometimes that's used as something that tarnishes the reputation of active managers to say, "Well, they lean on credit, and credit has done well." My response to that is, "Well, that's the point,” that you have an active manager that can lean on credit, that can utilize their expertise there in order to take advantage of the outperformance that credit will give you over time.
Andrews: Joe, are there any other points, any other features of short credit, short duration, that people might want to know about or people might not understand? Any insights you can bring there?
Graham: As I'm thinking about it, a point I missed [earlier was] on the idea that interest rates and diversifiability. One thing that we talk to investors about a lot is, "Well, how is interest rate risk priced in your portfolio?" I think that's a more current concern, because if you look at something called term premium right now, which is, "What are you getting paid to extend to a three-year bond from a two-year bond, or to a four-year bond from a three- will you get paid to extend, that extra year of risk?" In the last couple of years, you’ve been paying to do that, which is a very strange scenario.
Andrews: So you've had a negative term premium?
Graham: Exactly, a negative term premium. And so, there are all kinds of explanations that people come out with: it's the Fed operating in the middle part of the curve, it's liability-driven investing. Both of those things create very price-insensitive buyers that can create negative risk premiums [and] distortions in the market.
And actually that can be rational as well, that people can accept a negative expected return as long as it diversifies the rest of your portfolio. But that's the trick here, because what we've found is that over the last couple of downturns in the market-- think about what happened in January of '18-- where you had that hot wage inflation number, and then the S&P 500 went down somewhere around 12%, core fixed income didn't help you. It happened again in October .
Also it happened back in the Taper Tantrum [in mid-to-late 2013], and all those things are linked because it's when investors fear inflation or they fear Fed action—that the Fed is getting more restrictive—what happens is stocks and bonds tend to correlate more. So what that means is you need other risk in your portfolio, and short credit can be one of those risks. There are others.You know, active management in general can be a diversifying risk. But I think that's what's special about today's environment. With short credit, what we've found is that historically it overpays you. But even tactically, today there's a special need for short credit, because interest rate risk and equities are starting to correlate more.
Andrews: These have been some terrific insights, Joe, and we thank you for your time. Listeners can find links to the white papers we've been discussing here at lordabbett.com. Once again, thanks for listening.
Graham: Thank you.
VO: That’s it for this edition of The Investment Conversation. As always, you can access a full range of investment commentary and analysis at lordabbett.com. Thanks for listening.
ABS refers to asset-backed securities.
CLOs refers to collateralized loan obligations.
CMBS refers to commercial mortgage-backed securities.
IG refers to investment grade.
Fed refers to the U.S. Federal Reserve.
A basis point is a financial unit of measurement that is 1/100th of 1%.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the entire market or a benchmark.
Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.00 to -1.00.
A credit spread is the difference in yield between two bonds of similar maturity but different credit quality.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
Modern portfolio theory addresses how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk.
Sharpe ratio is a way to examine the performance of an investment by adjusting for its risk. It is theaverage return earned in excess of the risk-free rate per unit of volatility or total risk.
Spread duration is a bond's price sensitivity to changes in a defined measure of yield spread.
Standard deviation measures the dispersion of data from the mean. Applied to a rate of return, standard deviation is an indication of an investment’s volatility.
Taper tantrum is a term popularly used to describe the 2013 increase in U.S. Treasury yields which resulted from the U.S. Federal Reserve's use of tapering to gradually reduce the amount of monetary stimulus in the economy.
Term premium is a gauge of the level of risk inherent in holding a longer-term bond versus a series of shorter-term securities.
The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed- rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Bloomberg Barclays U.S. Corporate 1-3 Year Bond Index is a component of the Bloomberg Barclays U.S. Corporate Bond Index, which includes all publicly held issued, fixed-rate, nonconvertible investment-grade corporate debt.
The Bloomberg Barclays U.S. Universal Index represents the union of the following Bloomberg Barclays indices: the U.S. Aggregate Index, the U.S. High-Yield Corporate Index, the 144A Index, the Eurodollar Index, the Emerging Markets Index, and the non-ERISA portion of the CMBS Index.
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