- Fixed Income Portfolio Manager, Credit
France, Institutional
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Credit investing in an era of higher rate volatility
It’s no surprise that markets are still in a state of flux as we enter the second half of 2024. Several underlying forces are driving the new regime of higher inflation and cyclical volatility, among them, the deteriorating fiscal position in the US, a financial system awash with excess savings and liquidity, and the impact of escalating geopolitical risk on supply chains.
Against this backdrop, it is difficult for central banks around the world to set policy with conviction. At the same time, lags in monetary stimulus are becoming exacerbated, so the cycle of market swings and uncertainty continues.
For fixed income investors, we believe a key implication of this environment has been rising interest-rate volatility. In the US, volatility increased from 4.2% after the global financial crisis to 7.2% following the significant rebasing of US inflation in March 2022.1 Income-orientated strategies that hold large, static exposures to credit markets have felt the unsettling impact of this new era of higher US interest-rate volatility. (Figure 1).
Figure 1
Faced with these market dynamics, it has become increasingly important — as I discussed recently in this publication — to mitigate the risk of volatile interest rates while seeking to capture the opportunities available from the fluctuating performance of the US credit sector relative to US Treasuries. In my view, rotating between US credit sectors and US Treasuries as valuations evolve is a potentially compelling way of navigating this environment.
Adapting to a brighter US economic outlook
There are a number of bright spots in the outlook for the US economy. Among various factors, with household wealth looking relatively healthy and these assets generally not overly sensitive to interest rates, a slowdown triggered by reduced consumer spending looks less likely. I therefore see limited scope for downside in investment-grade credit spreads.
More specifically, the resilience of the business landscape reflects a prudent approach by many US corporates in recent years. This began during the pandemic, when companies took out debt and put cash on their balance sheets, akin to an insurance policy. They then chose to pay that debt down when the economy recovered more quickly than expected in 2021. Even before the chance for late-cycle re-leveraging in 2022, the US Federal Reserve started raising rates, so companies cut spending or dividends to protect balance sheets further. The upshot now is, I believe, a strong credit story.
By contrast, with the yield spread for US BB high-yield bonds hovering around 1.8% to 2%, these valuations are less appealing.2 That said, we believe attractive opportunities exist in certain sectors of the market — notably energy, global banking and some utilities — that are still pricing in disruption.
In my view, today’s investment landscape demands a nimble and dynamic approach to credit positioning. In particular, maintaining a higher level of “dry powder” while spreads are tight offers investors the potential to buy on dips when spreads are relatively more attractive.
Ready when markets reprice
To capitalise in this way, being selective across sectors counts. I favour issuers with sound balance sheets and positive fundamentals, and then seek the security structure likely to benefit from capital appreciation relative to the downside risk.
Applying this approach, many parts of the US financial sector currently appear attractive and are cheap versus the market on a historical basis. Equally, I prefer taking exposure to large US banks with high proportions of debt – and therefore potentially considered as “riskier” – rather than investing in a lower-rated US industrial name. By contrast, I view high-quality 30-year credit as less appealing amid the significant supply squeeze in that part of the market, which is leading to trades at very tight levels.
Carving out resilient and consistent outcomes
Today’s more volatile backdrop is a timely reminder that investors cannot predict the market environment. However, they can control the process by employing a resilient and consistent framework to continually assess the upside and downside risks of every decision and possible price outcome.
By doing so, investors can seek to achieve a more “all-weather”, total return experience and meet varied objectives through their credit allocation, for example:
- As a return enhancer/diversifier to duration/liability-matching allocations within a fixed income growth allocation.
- As a tactical complement to core fixed income and income/credit-focused allocations.
- As a return-enhancing replacement for an intermediate credit allocation.
Above all, I believe that by assessing the range of potential outcomes based on changes in the forward path of interest rates, credit spreads and the broader economic environment, a dynamic and flexible approach to credit investing has the potential to achieve attractive total returns across a range of market environments.
1Bloomberg US Treasury Index, 30 September 2008 – 30 April 2024. | 2The spread quoted shows the yield difference to Treasuries. Source: Bloomberg US BB high-yield Index.
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