Why considering credit now may make sense

Fixed income: why now for credit?

Credit investing will not be without risk, particularly in uncertain economic times, but conditions in the market have changed markedly over the last year, so Insight believes there are many features that mean considering credit now may make sense.

Increased income opportunities and scope for capital gains – Yields and spreads have risen markedly, such that there may be real potential for generating meaningful income from the asset class for the first time in a decade ormore, while also having the potential for enjoying capital gains should yields decline over time.

Fixed income may offer its traditional role as a diversifier relative to other risk assets – There may be the potential for diversifying risk, achieving meaningful returns from credit, if other asset classes such as equities lag behind in a future downturn.

More attractive entry point – Valuations have improved rapidly as credit spreads have risen and remain well above historic norms and at levels rarely experienced in more than 25 years.

Increased spread dispersion provides greater scope to identify and capture relative valuation opportunities – Valuations have improved rapidly as credit spreads have risen and remain well above historic norms and at levels rarely experienced in more than 25 years.

Increased credit spread more than compensates for default risk – In Insight’s view, credit spreads have risen above levels required to compensate investors for the risk of default.

The peak in the interest rate cycle may be approaching – If inflation has peaked and begins to moderate, expectations for gradual improvements in the economic backdrop, which have the potential to be more supportive for corporates, may start building.

The Return Of Attractive Fixed Income Features

Income-Based Long-Term Returns Now More Achievable

After an uncomfortable 2022, Insight believes 2023 will be a more attractive environment for credit investors. In driving absolute yields back to levels not seen since before the global financial crisis (see Figure 1), credit markets potentially offer a way to achieve long-term return objectives via income alone for the first time in many years, without the drawdown risk inherent in equity markets. After an uncomfortable 2022, Insight believes 2023 will be a more attractive environment for credit investors. In driving absolute yields back to levels not seen since before the global financial crisis (see Figure 1), credit markets potentially offer a way to achieve long-term return objectives via income alone for the first time in many years, without the drawdown risk inherent in equity markets.

Figure 1: Absolute Yields are back to levels where meaningful income returns can be generated

Source: Bloomberg as at 31 December 2022. ICE BofA Global Govt Index (W0G1), ICE BofA Global Corporate index (G0BC).

Figure 2: Yields available across the bulk of corporate credit markets have risen

Source: Bloomberg, Insight. As at 31 December 2022. ICE BofA Euro Corporate Index (ER00), ICE BofA US Corporate Index (C0A0), ICE BofA Euro High Yield Index (HE00), ICE BofA US High Yield (H0A0) Yield to worst (YTW). Candle charts shows interquartile range (between 25th and 75th percentile) as the solid body, plus 10th and 90th percentile extremes (line extensions).

Credit markets now widely offer yields well above previous levels

Five years ago, effectively all the Euro Investment Grade (IG) market was yielding less than 1.75%. The market turbulence seen lately, meant that by the end of 2022, more than 90% of that market was yielding more than 3.25%, while at least half had a yield greater than 4%. The Euro High Yield (HY) market has experienced a similar shift higher in the yields of its constituent base. At the end of December 2022, 85% of the index carried a yield of 5% or more. Five years earlier, 5% yield was available on less 10% of that market. The same has occurred in the US market where the bodies of the respective IG and HY indices have seen yield levels shift materially higher.
As Figure 2¹ shows, a yield of 5%-6% was commonplace in the US IG market, while 7%-10% was widely available in US HY. The higher levels of yield available across the market, that can be locked in until maturity, can provide an added
attraction for investors who have adopted a cashflow driven investment strategy.

Traditional role of fixed income and credit as a diversifying asset may have returned

Fixed income, and particularly credit, may offer the potential for offering diversification of risk if it can achieve positive returns should other risky asset classes, such as equities, languish in the event of modest economic weakness or an outright downturn. Those offsetting positive returns could occur if central banks end their tightening cycles or began to ease policy to overcome any slowdown.

Valuations have quickly improved compared to historic levels

Credit spreads for investment grade bonds have risen sharply in the past 18 months. When one considers the path of global credit spreads over the for the last 25 years and more, there have been few occasions when the spreads have exceeded prevailing levels. At the end of December 2022, the yield premium of the ICE BofA Global Credit Index was close to the 75th percentile level.

Figure 3: Elevated Corporate Credit Spreads Are Close to Historic Extremes

Source: Bloomberg, Insight. As at 31 December 2022. ICE BofA Global Credit Index (G0BC)

Figure 4: Credit Spread Dispersion Has Increased Across The Whole Euro Ig Market

Source: Bloomberg, Insight. As at 31 December 2022. ICE BofA Euro Corporate Index (ER00). Box and whisker charts shows interquartile range (between 25th and 75th percentile) as the solid box, and 10th and 90th percentile extremes (line whiskers). For illustrative purposes.

Dispersion Frequently Creates Opportunity

The turbulence in bond and credit markets can also be seen in a notable increase in credit spread dispersion. A greater dispersion of credit spreads across bonds that have the same credit rating offers active managers greater scope to find and potentially capture attractive relative value opportunities.

Compared to five years previously (December 2017), not onlyare yield levels higher as Figures 1 and 2 show, but there is also greater dispersion of spreads across the credit spectrum. For example, in the Euro IG universe in December 2017, the boxes and whiskers in Figure 4 were much narrower than in December 2022. As the dispersion of credit spreads within each credit bracket has widened, this may mean the capacity for achieving excess returns from relative value positions has the potential to be enhanced.

Default Risk Is More Than Adequately Compensated

In Insight’s view credit spreads have risen above levels required to compensate investors for the risk of default.

Although also driven by wider spreads, a key factor in the repricing of yields has been a dramatic upward shift in government bond yields. This may have increased the attractiveness of holding government bonds instead of credit, given they are widely regarded as being risk free. Investors may also have considered that credit is now too risky to hold given the uncertain economic outlook. Insight believes such a change in risk perspective is overstated. As Figure 5 shows, spreads remain sufficiently wide, across the credit spectrum in the three main markets, to provide a yield greater than the risk-free alternative, even when they are adjusted to reflect the effects on total spread should extreme levels of default arise (i.e. defaults at the 95th percentile of historic experience).

A Peak In The Rate Cycle Could Be Approaching

Although it may be too early to expect a material tightening in credit spreads, there are reasons to be more optimistic in the medium-term. Inflation may be peaking, indeed the highest level of headline consumer price inflation (CPI) in the US came in June 2022, while in the eurozone and UK, CPI levels have declined slightly in recent months also. Central banks may not ease their tightening pressure yet, but the potential for public and political pressure may mean they are likely to begin focusing more on the growth outlook before long if they can be comfortable that inflation is declining.

If credit markets can see that further rate increases are less likely and that the economic growth profile could soon improve, the corporate sector outlook could be supported and hence encourage spreads to begin tightening.

Figure 5: Spreads Over Government Bonds Remain Positive Even When Adjusted For The Effects Of Extreme Rates Of Default

Source: Insight, Moody’s and Bloomberg. As at 31 December 2022. We categorise extreme as being 95th percentile of historic default levels, and assuming a 40% recovery rate.

Associated Invesment Risks

Fixed Income

Where the portfolio holds over 35% of its net asset value in securities of one governmental issuer, the value of the portfolio may be profoundly affected if one or more of these issuers fails to meet its obligations or suffers a ratings downgrade.
A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.
The issuer of a debt security may not pay income or repay capital to the bondholder when due.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.
Where high yield instruments are held, their low credit rating indicates a greater risk of default, which would affect the value of the portfolio.
The investment manager may invest in instruments which can be difficult to sell when markets are stressed.
Exposure to international markets means exposure to changes in currency rates which could affect the value of the portfolio.
Where leverage is used as part of the management of the portfolio through the use of swaps and other derivative instruments, this can increase the overall volatility. While leverage presents opportunities for increasing total returns, it has the effect of potentially increasing losses as well. Any event that adversely affects the value of an investment would be magnified to the
extent that leverage is employed by the portfolio. Any losses would therefore be greater than if leverage were not employed.
While efforts will be made to eliminate potential inequalities between shareholders through the performance fee calculation methodology, there may be occasions where a shareholder may pay a performance fee for which they have not received a commensurate benefit.

The value of investments can fall. Investors may not get back the amount invested.

1292902 Exp: 30 June 2023

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Fixed income: why now for credit?

Figure 1: Absolute Yields are back to levels where meaningful income returns can be generated

Figure 2: Yields available across the bulk of corporate credit markets have risen

Figure 3: Elevated Corporate Credit Spreads Are Close to Historic Extremes

Figure 4: Credit Spread Dispersion Has Increased Across The Whole Euro Ig Market

Figure 5: Spreads Over Government Bonds Remain Positive Even When Adjusted For The Effects Of Extreme Rates Of Default

Related reading

The state of US opportunities

A return to the 70s?

Market watch

This is a marketing communication

INTRODUCING

Investor Solutions

Find out more

Reaching for Net Zero

Discover Income Solutions at Newton Investment Management

Discover the FutureLegacy Multi-Asset range

Fixed income: why now for credit?

Figure 1: Absolute Yields are back to levels where meaningful income returns can be generated

Figure 2: Yields available across the bulk of corporate credit markets have risen

Figure 3: Elevated Corporate Credit Spreads Are Close to Historic Extremes

Figure 4: Credit Spread Dispersion Has Increased Across The Whole Euro Ig Market

Figure 5: Spreads Over Government Bonds Remain Positive Even When Adjusted For The Effects Of Extreme Rates Of Default

Related reading

The state of US opportunities

A return to the 70s?

Market watch

This is a marketing communication

BNY Mellon FutureLegacy 4 Fund