2023-07-26 14:50:08 ET
Summary
- High-yield corporate bond credit spreads have moved below 4% this week, signaling a rich credit market.
- We take a look at some of the reasons why credit valuations have turned expensive.
- And highlight a number of securities from our resilient income playbook which should perform well when the market comes off its high.
High-yield corporate bond credit spreads have moved below 4% this week on the back of a broad-based rally in income markets. This move signals to us that the broader credit market is fairly expensive. And it is why we are, once again, reaching for our resilient income playbook and taking some chips off the table.
Below, we discuss some of the drivers of the latest rally, particularly in the high-yield corporate bond space, and highlight some resilient securities we find attractive in the current environment.
Why Is Credit Rich?
High-yield corporate bond credit spreads moved below 4% this week - quite a bit below the historic average of around 4.6% outside of recessionary environments.
Another useful metric we follow is how much credit spreads contribute to the yield of the average high-yield corporate bond. Recently, this metric fell below half which is a historically low figure. This means taking credit risk is not as compelling as it has been historically.
Part of the reason for optimism is obviously the disinflation story that we saw confirmed across various indicators this week, particularly in the headline CPI and PPI numbers. In addition, a better than expected claims number suggested that a soft landing is not to be ruled out.
Another support for credit markets is the stability in Treasury yields which have buoyed corporate bond yields above their historic average. Many investors are "all-in yield" investors meaning they allocate to bonds on the basis of the overall yield rather than the breakdown between Treasury yield and credit spreads. This keeps demand for corporate bonds healthy as overall corporate bond yields remain fairly high.
Finally, the high-yield bond market has actually shrunk by almost $200bn since its peak in late 2021, constraining available supply for investors keen to put capital to work.
The sharp rise in interest rates has kept some companies on the sidelines, deterred by high levels of interest expense. Other companies have been upgraded to the investment-grade market ($81bn of upgrades this year vs. $16bn that was downgraded to HY).
And yet others are turning to private lending - a red hot area of markets which has grown rapidly over the past decade and is now bigger than either the bank loan or HY bond markets.
New borrowings in the HY market numbered just 39 totaling $33bn - the lowest year-to-date deal count as of Q2 since 1995 and the lowest dollar amount since 2009.
What, Me Worry?
Most income securities staged an impressive rebound in the last few weeks. business development companies, or BDCs, are up by double-digits since the start of the year and by 5% since the start of 2022.
BDC valuations have nearly converged with their longer-term average.
Closed-end funds, or CEFs, are up around 15% from October lows, though the space is still below its early 2022 level.
Why Resilience Matters
Some investors take the view that drawdowns don't matter a whole lot so long as they are clipping the dividends. And it's true that a drop in the price of a particular security is not the end of the world so long as the dividends keep coming. It's also true that a drop in price can allow investors to reinvest dividends at higher yields. However, drawdowns come with their own set of challenges which shouldn't be swept under the rug.
First, a drawdown in the price of a given security may very well be permanent which, in turn, can lead to a permanent drop in an investor's wealth. This is an obvious problem because it reduces the investor's ability to actually use their wealth for something else, whether it is to buy a home or leave a sizable legacy portfolio.
Two, securities with large drawdowns during periods of volatility make it difficult to reallocate capital to more attractively priced assets. In other words, buying an attractive asset that is down 20% by selling another asset that is also down 20% limits potential gains than selling an asset that is down only 2%. It's obvious that, in the latter case, more capital is available to buy the 20% - down security. A lack of resilient holdings limits the ability of an investor to take advantage of periodic drawdowns to not only grow their overall wealth but also grow their income stream.
Three, few investors can "keep calm and carry on" while their portfolios take heavy losses. The bigger the drawdown the less conviction a typical investor will be able to maintain in their portfolios and the more likely they are to get out and sell at low prices. This suggests that investors who are able to maintain some ballast in their portfolios may be better able to avoid locking in economic losses during periods of volatility.
What We Are Doing
Due to the relatively rich credit environment, we recently pared down our allocation in favor of what we view to be more resilient securities. These securities tend to share a number of features - they tend to be of higher quality, with a shorter duration profile and without any explicit leverage or discount dynamic.
These include the following:
- Multi-sector Credit ETF PIMCO Multisector Bond Active Exchange-Traded Fund ( PYLD ) with a higher-quality profile.
- Investment-grade CLO Debt ETF JBBB B-BBB CLO ETF ( JBBB ), with a 10.6% portfolio yield.
- Mortgage REIT AAIC 2026 bond ( AAIN ) with an 8% yield.
- CEF OXLC 2027 bond ( OXLCZ ) with an 8.5% yield.
- Mortgage REIT Annaly preferred ( NLY.PF ) with a 10.5% yield.
It should be said that there are always significant uncertainties in markets and that valuation is never perfect. However, the key point is that it's important to allocate to resilient securities when markets are doing well rather than when they are falling apart.
In other words, rotating from high-beta securities to lower-beta options when the sell-off has already happened simply locks in losses and likely reduces longer-term investor wealth since it's akin to buying high and selling low.
Rather, allocating to lower-beta, resilient securities when markets are doing well allows investors to deploy this dry powder to higher-beta / higher-yield assets when markets tumble. This kind of countercyclical approach to income allocation is much more likely to generate higher wealth longer-term.
Takeaways
Headlines that promise securities that will "soar", "fly" or "zoom" are a dime a dozen. What can be more useful to some investors than promises of boundless upside are securities that don't collapse in a period of market weakness. Such securities carry a low opportunity cost versus other even higher-yielding assets, particularly in strong markets, while providing investors with a relatively stable base of capital from which to chase higher-beta opportunities during drawdowns. This can allow investors to sustainably grow the income level of their portfolios and generate significant alpha over time.
For further details see:
Why We Are Turning Again To Our Resilient Income Playbook