United States
We continue to see significant interest from investors in fixed income given high absolute yields and falling interest rates. However, in a world of tight credit spreads, we believe it is no time for “lazy longs”. An intentionally managed multi-sector approach may be the best way to re-enter bonds.
Credit looks well positioned to withstand a moderating economy
Insight’s economic “regime” analysis indicates that GDP growth is slowing from its recent ~3% GDP trend, but is potentially stabilizing, indicating an “orderly moderation” of economic activity.
This could suit credit markets. On average, they have historically delivered equity-like returns during modest growth environments, but with the comparative certainty of contractually pre-determined cashflows (Figure 1).
Figure 1: Moderate positive or negative environments tend to suit credit markets1
Further, we believe that corporates are fundamentally well positioned for a moderating economy. EBITDA margins are at record levels, interest coverage ratios are also secularly strong and net leverage is relatively healthy (Figure 2).
Figure 2: Credit metrics are secularly strong, and falling rates may help reverse near-term falls in interest coverage2
Technicals also appear favorable. Investment grade credit inflows have accelerated through the year and surpassed all other major asset classes as a percent of AUM (Figure 3), allowing markets to comfortably absorb close to $1.5trn3 of issuance so far this year.
Figure 3: Fixed income inflows, particularly investment grade, have been strong4
However, we believe investors need to avoid “lazy longs”
While bond yields remain attractive in our view, credit spreads have tightened in from their widest levels of the last three years.
A broad overweight credit allocation (often a hallmark of Core Plus strategies) could potentially expose investors to bouts of market volatility, particularly in an environment characterized by elevated geopolitical risks and a presidential election campaign.
We see this as more compelling than a “lazy long” (a static and broad credit overweight, which fare less well in an environment of winners and losers). Following the 2008 global financial crisis, many core plus strategies were structurally overweight all credit. It worked in almost all years from 2009 to 2019 but came unstuck into the pandemic.
We believe that investors should consider a more intentional and dynamic multi-sector Core Plus strategy, that focuses on security selection, multi-sector diversification and dynamic sector rotation.
As investors allocate to fixed income, we see three key ways they can seek to position to optimize their exposure:
1) Enhance credit spread through security and sector selection
Targeting relative value through diligent bond-picking can potentially exploit market inefficiencies to improve spread without increasing credit risk.
For example, we currently believe utilities offer an outsized premium relative to industrials and financials relative to non-financials. In our view, both sectoral spread differentials have the potential to revert to historical norms. Investors may benefit from rigorous security selection within these sectors. For those able to take advantage of global credit markets, there may still be security-specific opportunities to secure a spread pick up in European credit for equivalent risks to comparable bonds issued in the US market (Figure 4).
Figure 4: Utilities and financials may offer compelling relative spread value5
2) Enhance spread through high quality esoteric structured credit
Within the structured credit market, we currently see particularly attractive value in “esoteric” asset-backed securities. Esoteric fixed income is the fastest-growing “non-traditional” credit market. We estimate outstanding issuance was at $400bn at the end of 2023, up ~$100bn since 20206.
At present our favored sectors include certain consumer-related deals, such as AAA-rated home improvement ABS, backed by loans to high income homeowners with high levels of home equity. They currently offer spreads in the region of 100bp above Treasuries for AAA credit risk7. We also see value in deals backed by aircraft loans and datacenters where we find investors can reasonably access spreads of 150bp to 200bp above Treasuries7. However, across all these deals, rigorous issuer selection and consideration for deal terms is crucial.
Figure 5: Esoteric structured credit can potentially offer wider spreads yet high credit quality8
3) Sell less attractive lower rated credit into Treasuries for diversification and dry powder
In areas where credit spreads have rallied and offer less compensation for risk, potentially such as lower rated high yield credit and less attractive sectors outlined above, investors may wish to tactically sell some that exposure into Treasuries. Due to the yield environment, we believe investors can still achieve meaningful income and benefit from capital gains if yields fall in the event of a “flight to quality” event which benefits Treasuries.
Treasuries effectively act as “dry powder”, i.e. a liquid vantage point from which to take advantage of any market volatility (and associated risk market sell offs) to add credit exposure at wider spreads.
We find markets are often highly reactive to market noise and newsflow. With political risk events on the horizon alone, we believe patience and a rigorous value-based approach may be rewarded.
Conclusion: as you return to fixed income, be intentional
As investors look to lock in fixed income yields and take advantage of rate cuts, we believe they should avoid “lazy longs”. In our view, a multi-sector Core Plus strategy that prioritizes security selection and dynamic rotation between sectors can offer investors an optimal platform to lock in yields, optimize spreads and hold dry powder to help exploit potential bouts of volatility.
