Diving into the new world of credit

We believe that in this more cyclical era, bond investors can capture attractive income across the quality spectrum, but doing so may involve proactively revisiting widely held assumptions. 

With cash providing a healthy yield, isn’t it better to wait for clarity from central banks?

We have seen significant flows into cash and cash-like products over the last two years, driven by the fact that cash has been able to offer a healthy yield at low levels of risk in an uncertain environment. However, while this sounds appealing, it is not entirely without risk. Once a growing percentage of central banks start to cut rates, short-term rates will adjust quickly, and with each cut, investors’ exposure to reinvestment risk will translate to ever-decreasing interest earned on assets. 

Crucially, as well as offering an income stream similar to cash, high-quality bonds also embed downside protection, should central banks deliver on rate cuts in the near term. We can see evidence of this by looking at similar periods in the recent past where cash has tended to underperform all major fixed income categories once rate cuts got underway. 

Specifically, we analysed the three-year total returns of cash, government bonds, corporate bonds and short-duration corporate bonds starting from the last hike of each of the past six full US Federal Reserve interest-rate-tightening cycles since 1980. As Figure 1 illustrates, returns for all types of bond strategies were significantly higher than cash: even though some bonds have lower yields than cash, on average they've benefited materially more than cash in the past six rate-cutting cycles.

Figure 1

Why does cash underperform versus fixed income in those circumstances? First, fixed income investors don’t have to reinvest in a lower-interest-rate environment, as they have already locked in higher yields. Second, the duration component of bonds tends to boost performance in the event that the mid or long end of the yield curve is also adjusting downwards. Finally, an extended period of rate cuts typically supports economic growth, which, in turn, can lead to tightening spreads, which benefit corporate bond investors. 

While all high-quality fixed income categories in the above example outperformed cash, longer-duration bonds tended to outperform shorter-duration bonds. However, we should remember that longer-term bonds are associated with higher volatility. If the potential interest-rate volatility is perceived as too risky, short-duration approaches can allow for a spread pick-up relative to cash while also benefiting from inverted yield curves (higher rates in the shorter end of the curve) with moderate rates exposure and therefore lower expected volatility.

Now that spreads have tightened, is it too late to invest in credit?

True, credit spreads tightened significantly in 2023 leaving limited scope for further spread compression. That said, we believe that earning the credit spread should continue to be attractive, even if no further material tightening takes place.

A major global recession does not appear to be on the table; in fact, global purchasing managers’ indices are suggesting growth may well accelerate. Consumers remain relatively robust and companies seem to be well-capitalised. While we see weakness in certain sectors, we expect that the credit cycle will be extended and foresee no maturity wall with companies forced to refinance en masse. These circumstances suggest that spreads could well remain tight. In other words, given the likely absence of a significant downturn, why not earn the credit spread, even if spreads might not tighten materially like they did last year?   

What can an active approach offer me that passive can’t?

Markets may still be anchoring to the old regime of central banks stepping in when the pressure gets too high, but we think the age of easy money is gone, meaning that passive portfolios may be more vulnerable than in the past to the adverse impact of deteriorating credit conditions. 

One key way in which an active approach can help investor outcomes relates to the composition of indices. By investing passively in investment-grade credit, investors are bound to the sector and issuer exposures of the reference index. This can be a problem if investors are inadvertently exposed to risks they would rather not take, which may be exacerbated in an era of cyclicality and divergence. 

The recent travails faced by the European property sector illustrate this problem. As elsewhere across the world, real estate in Europe benefited greatly from ultra-low interest rates. Between 2018 to 2022, the sector’s weight in the Bloomberg Euro Aggregate Corporate Index grew from 3.3% to 7.6%.However, as the impact of higher interest rates began to bite, the sector materially underperformed the rest of the European corporate index. As a result, passive investors were significantly exposed to undesirable risks, by virtue of tracking highly indebted sectors and issuers. 

Active managers can also identify downgrades before they happen. At the end of 2021, the Bloomberg Euro Aggregate Corporate Index held 96 real estate issuers. As of 30 June 2024, that number had dropped to 82 as some issuers have been downgraded and left the index. Fundamental research can help active managers identify deterioration or improvement in a credit before the rating agencies do, and even before the shift is priced in by markets. At the very least, higher leverage should be a clear warning sign for credit teams to investigate a company’s earnings and free cash flow, its plans for asset sales and dividends and how committed its senior management is to investment-grade ratings. 

In the new regime, we believe bond investors can capture attractive income, which contributes to total returns, at all points in the quality spectrum, but it is important to make sure that outdated assumptions don’t stand in the way of success.