Institutional Perspectives
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.
A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
A basis point is one one-hundredth of a percentage point.
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.
Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point).
Yield to maturity is the rate of return anticipated on a bond if held until it matures.
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. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.
The Bloomberg Barclays U.S. Corporate High Yield Bond Index is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market. The index is composed of U.S. dollar-denominated corporate debt in Industrial, Utility, and Finance sectors with a minimum $150 million par amount outstanding and a maturity greater than 1 year. The index includes reinvestment of income.
The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The credit quality of the securities are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.
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The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.