Why Credit? Why Now?

Our experts review the case for allocating to credit-sensitive assets such as U.S. high yield and short-duration credit in today’s market.

In Brief

• Due to a variety of dynamics in the fixed-income market, we would argue that current conditions justify adding credit to existing allocations.
• First, credit spreads historically have more than compensated investors for potential losses from default.
• Second, since U.S. Treasury bonds occupy a greater share of the investment-grade universe, investors may have less credit risk in their portfolios than ever before.
• Finally, we believe that U.S. credit spreads don’t look particularly tight when considering substantial improvements in underlying fundamentals in the high-yield market.

History shows that given enough time, higher-yielding investments have generated higher returns for investors than lower-yielding assets. These higher returns come with a cost, however; returns are typically more volatile, and investors may endure extended periods of negative returns.  Many investors will treat credit-sensitive investments cautiously, or avoid them altogether, due to the risk of permanent loss from default, or because the risk profile for credit may be similar to other investments, such as equities.

However, this risk of loss from default, while certainly a factor to consider, historically has not had a significant negative impact on the overall investor experience; compensation for those risks tends to greatly exceed actual losses. Nonetheless, many investors will invest tactically in credit, trying to time their investment to avoid periods of loss, and adding to positions when they feel better about the state of the credit markets.  Invariably, the question of when to buy and sell arises and some may ask: “Is now a good time to invest in credit?”

In fact, the historic differential between compensation and losses is so significant that we wonder if this question should be turned on its head, to wit: “Is now the right time to sell credit?” Yet even then, the differential between compensation and losses from default is so significant that investors would need to be exceptionally skilled in market timing in order to justify reducing this exposure.

The difficulties of market timing aside, our view is that this is not a good time to reduce exposure to credit, even though compensation (in the form of credit spreads) is below historic averages, and despite oft-voiced concerns over growing problems in credit markets.  Due to a variety of dynamics in the U.S. fixed income market, we would argue that current conditions may justify adding credit to existing exposures for some investors. Here, we explore what we consider to be three compelling rationales for credit in today’s U.S. fixed-income market.

Rationale 1: Credit historically has done well even during periods of rising defaults.
As mentioned earlier, credit spreads historically have more than compensated investors for losses from default.  In fact, our research has found that historic averages for losses from default are less than 10% of spreads over U.S. Treasuries.  Notably, this differential is large enough that it can potentially benefit long-term investors even during periods of rising defaults.

This relationship holds true across all investment-grade (IG) rating categories.  Examining historic loss rates (see Chart 1), we see that even in extremely difficult economic environments, such as 2008, the loss rate of ‘BBB’-rated credits barely rose above 70 basis points (bps) annually, compared to today’s BBB credit spread of 134 bps.  Our analysis shows that investment grade corporate credit can be a worthy addition to many kinds of portfolios under a range of scenarios, including recessions and periods of increased defaults.
 

Chart 1. Annual Credit Loss Rates and Yield Spreads for U.S. Investment-Grade Debt by Letter Rating, 1996-2017

Source: Moody’s and Bloomberg. OAS=Option-adjusted spread.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk.
 

Rationale 2: Issuance changes have resulted in less credit to go around.
A common narrative we hear from investors is that we are now seeing one of the signs that an economic cycle is nearing an end: a decline in the quality of corporate balance sheets due to a surge in borrowing.  However, a quick look at the composition of the Bloomberg Barclays U.S. Aggregate Bond Index (Barclays Agg), a composite of the entire universe of investment grade debt in the United States, shows us that debt markets today are in fact dominated by U.S. Treasury securities.  To the extent that investors have maintained general exposure to fixed income markets, they likely have less credit risk in their portfolios than ever before, even as low yields might seem to justify incremental exposure to the higher returns associated with credit. 
 

Chart 2. The Biggest Aggregation in the U.S. “Agg” Is Government-Related Debt
Composition and characteristics of the Bloomberg Barclays U.S. Aggregate Bond Index, as of September 30, 2019

Source: Bloomberg Barclays Indices. Data as of September 30, 2019.
¹“Other” refers to sovereign, supranational, and local authorities.
²Represents modified adjusted duration of the Bloomberg Barclays U.S. Aggregate Bond Index.
³Represents yield to maturity of the Bloomberg Barclays U.S. Aggregate Bond Index.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

In fact, if we consider the change in composition of the Barclays Agg, we can see that the proportion of the index invested in U.S. Treasuries has nearly doubled over the past decade.  Notably, the duration, or sensitivity to interest rate risk, has risen substantially over that same period.  On average, investors in U.S. fixed income have more exposure to interest rate risk than ever before, and relatively less exposure to credit.  All else being equal, we think investors should consider actively adding credit risk to their portfolios simply to stay neutral to historical allocations, if that suits their individual investment objectives. 

Rationale 3: Credit spreads may be more attractive than they seem.
Credit spreads have rallied heroically since January 2019, including double-digit returns for U.S. high yield (as represented by the Bloomberg Barclays U.S. High Yield Index), leading some investors to be skeptical about the value proposition in credit overall, and the wisdom of buying high yield at apparent market “highs.”  Critics will often cite current characteristics of the U.S. high yield market--comprised of speculative grade credits and with spreads tighter than historical averages--as evidence that this is a poor entry point for credit investors.   

However, closer scrutiny of the data would suggest otherwise.  Looking at spreads versus historical averages obscures substantial improvements in the underlying fundamentals.  We find that the U.S. high yield market’s quality and composite rating has actually improved over time (see Chart 1), with balance sheet leverage essentially sitting at the midpoint of the post-financial crisis period.  On a ratings basis, ‘BB’-rated bonds now account for the largest proportion of the U.S. high-yield market at 46%, while ‘CCC’-rated issues account for just under 15%. Compare that to the respective levels of 36% and 21% credit spreads troughed in the last cycle in 2007—approximately 130 bps tighter from today’s level. 

Chart 3. BBs are Now the Largest Segment of U.S. High Yield While CCCs Have Shrunk in Proportion
Composition of the Bloomberg Barclays U.S. Corporate High Yield Bond Index on the indicated dates

Source:  Bloomberg Barclays Indices. Data as of September 30, 2019.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.
 

Further, we note that the duration of the U.S. high yield-market has fallen by one-third since 2007, based on data from Bloomberg Barclays Indices.  A number of factors have driven that result, including the reality that the size of the high-yield market opportunity has basically trended sideways the last several years, as existing debt is either refinanced with shorter maturities or redeemed completely.  This fall in duration is a favorable outcome should there be upside risk in benchmark interest rates, with the U.S. Federal Reserve (Fed) adopting a more balanced policy posture and economic data continuing to discount the possibility of a U.S. recession in the near term.  This dynamic also contrasts favorably with the growth in interest rate risk exposure (via increased supply of U.S. Treasury securities in the market) in the broader fixed-income markets

Finally, the limitation of deductibility of interest expense for tax purposes under the 2017 U.S. tax code reduces the tax efficiency of debt for lower-quality issuers. We believe that should lead to an improvement in credit quality in the years ahead, all else being equal. 

All the factors we’ve noted here lead us to believe that U.S. high yield credit spreads have potential to tighten further from current levels, and that they don’t look particularly tight when examined in a historical context. 

At Lord Abbett, we have long sought to harness the historical return profile of U.S. high yield within broader strategies. In fact, we have spent nearly five decades refining a strategy that seeks to provide attractive return while mitigating volatility via a multi-sector approach that strategically blends credit with term risk and equity beta, tactically allocating among sectors as we identify relative value.  In our view, decades of strong results serve as a testament to the attractiveness of credit as an asset class for both short- and long-term investors.

Summing Up
Over time, credit-sensitive investments have provided higher returns to investors versus lower-yielding assets. We believe that current conditions do not warrant an underweight to credit for some investors.  Too many investors view reducing credit in a portfolio as decreasing risk, without realizing that credit may diversify the increasing concentration of interest-rate risk.  Instead, we believe investors should be looking to increase returns and diversify risk by utilizing credit as a strategic allocation in their portfolios, if it suits their investment objectives.