Credit: Two Major Considerations for Today’s Market | Lord Abbett
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Market View

We address questions about rising U.S. inflation and interest rates, as well as recent U.S. credit spread levels.

Read time: 3 minutes

How might credit respond to a potential acceleration in inflation? And given the recent tightening in spreads, might investors expect to be adequately compensated for taking credit risk? Here, Market View addresses these questions in an edited excerpt from an upcoming whitepaper by Lord Abbett Managing Director and Investment Strategist Joseph Graham.

  1. Navigating Inflation and Rising Rates

Inflation can wreak havoc for risk pricing—certainly in interest-rate sensitive bonds, but also in equities which can struggle with rising discount rates on long-dated earnings when inflation increases above modest levels.

One historical exception to this trend is credit. Generally, credit responds well to inflation as companies and securitized structures use rising nominal revenue--reflecting the stepped-up pace of inflation--to pay a fixed debt. It’s worth noting that the last time inflation was a real problem (the late 1970s) the burgeoning U.S. high yield market produced extremely strong returns. Though markets are much different now, the historical attractiveness of credit during periods of rising rates remains, as shown in Figure 1.

 

Figure 1. Credit Has Offered Strong Performance During Periods of Rising Yields
Returns during recent periods of greater than 100 bps rise in the 10-year U.S. Treasury yield

1FTSE 10 Year Treasury Bond Index. 2Bloomberg Barclays U.S. Aggregate Bond Index. 3Bloomberg Barclays U.S. TIPS Index. 4ICE BofA U.S. Corporate BBB-Rated 1-3 Year Index. 5 Credit Suisse Leveraged Loan Index. 6ICE BofA U.S. High Yield Constrained Index. 7ICE BofA Convertible Index. TIPS = Treasury Inflation-Protected Securities. Performance data quoted reflect past performance and are no guarantee of future results. Performance during other time periods may have been different or negative. Other indexes may not have performed in the same manner under similar conditions. Source: Morningstar. For illustrative purposes only. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. *Returns for periods of greater than one year have been annualized.

 

  1. Getting Compensated for Credit Risk

Many investors might question whether now is the time to be taking credit risk. Spreads on much of the credit universe are near pre-pandemic tights. However, we believe there are persistent features of the current market that should drive credit risk tighter for the foreseeable future.

To understand the likely future direction of credit spreads, it’s worth reviewing what you are getting paid for in a credit spread, which, depending of the composition of the portfolio, is varying amounts of liquidity and default risk. Spreads in portfolios of high quality and short maturity bonds are largely comprised of liquidity risk, as losses from default are historically very small relative to overall spread, even in difficult credit environments. As portfolios move out in maturity and down in quality, default risk becomes a larger portion of the overall credit spread. Both liquidity and default are fundamentally very well positioned today and, in our opinion, will drive credit spreads tighter in the future.

Liquidity—We believe the liquidity premium assigned to credit likely deserves to be less going forward. The coordinated action of the Fed’s intervention in credit markets and fiscal spending in March 2020 brought a paralyzed fixed income market back to life. As such, there is a roadmap for liquidity crises for the future and the potentially negative impact of elevated liquidity risk is likely muted in both probability and severity.

Default—Though defaults peaked at a significant 6% in for high yield issuers in 2020, the peak was short lived and there were no major investment grade issuer defaults. In fact, as discussed in the June 1 Market View, each recession in the last 30 years has come with a less severe default environment. This is the result of some combination of corporate behavior and government intervention and we believe is likely to be a secular feature of the U.S. market that mirrors developments in other major economies in Europe and Asia, where default rates have been lower for decades. In our view, the current quality of the market, the availability of refinancing, and fundamental features like growth, margins, and cash levels all support the likelihood of very low default rates in the immediate future.

 

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 commentary 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. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

TIPS (Treasury inflation-protected securities) are U.S. Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation. The principal of a TIP is adjusted according to the CPI-U. With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases. Though the rate is fixed and paid semi-annually, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate. Upon maturity, TIPS pay the original or adjusted principal amount, whichever is greater. Because TIPS are adjusted for inflation, a change in real interest rates (but not nominal interest rates) will affect the value of TIPS. When real interest rates rise, the value of TIPS will decline, and when real interest rates fall, the value of TIPS will rise.

basis point is one one-hundredth of a percentage point.

Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.

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. TIPS Index is an unmanaged index comprised of U.S. Treasury Inflation Protected Securities with at least $1 billion in outstanding face value.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.

The FTSE 10 Year U.S. Treasury 10 Year Bond Index is designed to measure the performance of U.S. Treasury securities with a maturity of 10 years.

The ICE BofA U.S. High Yield Constrained Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.

The ICE BofA U.S. Corporate BBB-Rated 1-3 Year Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.

The ICE BofA U.S. Convertible Index tracks the performance of publicly issued U.S. dollar-denominated convertible securities of U.S. companies. Qualifying securities must have at least $50 million face amount outstanding and at least one month remaining to the final conversion date.

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

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 is 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 principal on these securities.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

 

The opinions in this commentary 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.

 

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