Credit investments often sit in the equity market’s shadow as their elevated position in the capital structure means they should be less rewarding in the long run. In the recent market sell off credit cheapened up materially and we believe that it represents a great risk adjusted opportunity from here. Credit investors are paid to wait and, given how much equity markets have risen from the bottom, that patience may well pay off.
How has credit performed during the recent volatility?
Credit markets are often credited – no pun intended – with leading equities, at least on the way down. The innate optimism of the equity investor tends to trump the more cautious credit investor meaning that the latter usually departs the party before the last song has played. The Coronavirus induced sell off however, played out slightly differently in Q1 as developed market (DM) credit lagged DM equity by a few weeks. This meant that March was a particularly painful month for credit with global high yield underperforming global equities. Not only that, but it had a higher participation rate in the equity downside than in previous sell offs of recent years – a characteristic not unique to credit either as we have noted in prior updates.
Emerging market (EM) credit – both sovereign and corporate bonds – started to sell-off at roughly the same time as DM corporate credit, thus lagging EM equities by a wider margin as the EM indices started wavering in January on the Coronavirus newsflow emanating from China. In summary, March was painful, but not entirely unexpected given valuations (credit spreads) and yields were close to record lows going into this episode.
April saw most risk assets bounce back with global equities recouping most of their March losses, and the US posting the best monthly return since 1987. High yield credit however made only modest gains and performance trails equities by over 8% over the two months. Clearly there are regional and sectoral differences across the global equity and credit divide which in part justifies the divergence in cross asset class performance. Nonetheless, one could posit that global equities have run up too far, or that global credit looks cheap.
What is priced into credit markets?
The speed and magnitude of the credit sell off was extraordinary. Although spreads went wider at the peak of the financial crisis than they did in the recent episode, it happened at a far faster rate this time round. What took over a year to occur in the build up to the Lehman’s default took just a few weeks this March. This has left credit looking attractive to us on an outright basis for the first time in years. The ‘dash for cash’ pushed prices down and spreads up to levels that we think provide ample compensation for the associated credit risk. In reality, investors are being handsomely rewarded as providers of liquidity to a swollen, but largely solvent investment grade market. This was in part borne out when several bellwether ETFs traded at sharp discounts to their NAVs, persisting for several days until the Federal Reserve stepped in.
The table below depicts the implied five-year cumulative default rates (assumed recovery rate of 40%) that one can back out from credit spreads. We have shown these at the March peak and April month end. Each asset class shown has an implied default rate higher than anything seen during either the financial crisis or the TMT bubble 20 years ago (when sector concentration in the high yield market was much higher than it is today). The way to interpret this chart is that if future five year defaults realise at a rate less than that implied, then investors will earn a positive credit risk premium. In reality we might expect credit spreads to compress in the intervening period and for investors to take this excess premium up front as a capital gain. Even when stressed at lower recovery rates the numbers still look good.
We recognise that credit quality within investment grade has drifted lower in recent years as companies have taken advantage of cheap debt, but it would be sub optimal from a corporate financing perspective not to have done this and it is one reason why corporate margins have sustained their high level in recent years. The fact is that in aggregate the debt servicing ability remains reasonably solid and the higher quality businesses will come through this. Companies will be downgraded – we are seeing this already – and some businesses will go under (think oil services and exploration), but for active managers that can operate across the investment grade and high yield divide – what we call the ‘crossover’ space – there will be ample opportunities to profit in this less efficient part of the market.
We allocated to an active crossover strategy in early April, taking additional comfort from the extraordinary amount of support being provided to credit markets, particularly in the US. The Federal Reserve’s Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF) would provide liquidity to the investment grade market and to ‘fallen angels’ – bonds that had been downgraded from investment grade such as Ford – through both direct purchases and the purchase of US listed ETFs, including high yield ETFs for the first time. We believe that as both liquidity and the global economy slowly get back to normal the default risk embedded in credit markets will fall back. This may take some time, but you earn a reasonable return while you wait with global investment grade and high yield bonds yielding 2.3% and 9.4% respectively versus less than 0.5% on global government bonds.
More recently, following the dizzying April rebound in US equities, credit arguably looks more attractive still. As mentioned earlier a gap has opened between credit and equities over the course of the last few months. That makes convertible bonds increasingly attractive as a way to maintain equity upside, but also to benefit from the credit qualities of convertibles at a time when the embedded options look somewhat cheap. When credit and equities are pointing in different directions, they can be a useful risk management tool. With that in mind we have increased the allocation to convertibles in our funds over the last couple of weeks as equities moved higher.