A Decade of Credit, August 2014
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The document discusses how investors should allocate to different credit asset classes in the current market environment. It notes that different credit sub-asset classes perform better in different market cycles, with some benefiting from growth periods while others protect capital during downturns. Recently, high yield bonds have seen strong returns but spreads are now close to fair value, so a more dynamic approach across credit quality and regions may be better. Carefully selected absolute return, credit relative value, and multi-class credit strategies could add value going forward.
A Decade of Credit, August 2014
- 1. A DECADE OF CREDIT How Should Today’s Investors Allocate to Credit?
- 2. 0 6 8 10 12 14 16 18 2 4 -6 -8 -10 -12 -14 -16 -18 -2 -4 GLOBAL TREASURY GOVERNMENT RELATED CORPORATE SECURITISED HIGH YIELD EMERGING MARKET SOVEREIGN (LOCAL) GLOBAL LOANS EMERGING MARKET SOVEREIGN (HARD) Over the different stages of a market cycle, different credit sub-asset classes play different roles. Some are more likely to benefit from a growth environment, while others are more likely to protect investors’ capital during times of crisis. Market cycles drive the returns of credit assets. In the first half of 2014, credit asset classes continued to tighten as the global economy started to recover. The UK and US economies have both shown signs of growth. Markets have focused on the potential impact from the possibility and timing of monetary policy tightening. In Europe, growth is less prominent. Therefore there is likely to be a longer period of more accommodative monetary policy. In such a dynamic market environment, some opportunities which have historically appeared attractive may not always remain so. As can be seen on the previous page, high yield bonds have seen strong returns since 2009 as investors hunted for yield in a low interest rate environment. In the first half of 2014, high yield bonds returned 6.1%. Consequently, over the period, the credit spreads as well as the yields of high yield bonds have tightened to historical lows. As of July 2014, Redington’s internal analysis shows that the credit spreads of high yield bonds are now close to their fair value spread (i.e. credit spreads compensate for default losses). In this case, therefore the risk of potential losses in a long-only allocation has started to outweigh the potential rewards from spreads tightening further. Therefore, a more dynamic approach which allocates to different credit sub-asset classes, across the credit quality spectrum and geographical regions, could better take advantage of the changing market. Redington believes that carefully selected absolute return bond, credit relative value and multi-class credit strategies could add value in the current market environment. Historical monthly return distribution of the different credit sub-asset classes Global Treasury, government-related and securitised bonds, represent the conservative end of the credit sub-asset classes. As can be seen in the chart above, historical returns have a smaller range in these asset classes. On the other extreme, while high yield bonds, global loans and emerging market debt have much higher returns on the upside, they also expose investors to potentially large losses on the downside. The return distributions are not symmetric, investors in these asset classes have faced potentially larger downside than upsides from returns. How Should Today’s Investors Allocate to Credit? MONTHLYRETURNS(%)
- 3. A Decade of CreditThis chart shows the calendar year returns on each credit sub-asset class since 2003. Fixed income investments in general have enjoyed strong rallies in the past decade. For 8 out of the 11 full calendar years in our analysis horizon, all credit sub-asset classes generated positive returns. As interest rates fell over the past decade, global treasuries generated positive returns in every single year. When financial markets became very distressed in 2008, global treasuries returned 9.1% as investors sought safe haven assets. The securitised sector has also performed consistently through time. Investments in the securitised sector are backed by pools of financial or physical assets. This collateral provides some degree of capital protection in distressed market conditions. When markets are benign, sub-investment grade investments such as high yield bonds and global loans, have topped the return charts alongside hard currency and local currency emerging markets’ sovereign debt. However, these assets suffered severe performance drawdowns in 2008 when all risky assets sold off. Investment grade corporate bonds have participated in the aforementioned interest rate rally in the past decade. In 2008, corporate bonds suffered a modest loss of 5.1% as the combination of widening credit spreads and falling interest rates offset each other to some extent. Corporate bonds which are rated below investment grade (high yield bonds have ratings of BB+/Ba or below). Investors in high yield bonds look for compensation through higher returns for greater exposure to default risk. HIGH YIELD US Dollar and Euro denominated leveraged loans are privately arranged floating rate bank loans, used to finance companies, are syndicated by groups of banks and institutional investors. Leveraged loans are senior debt instruments secured by a lien on the assets of the borrower. These loans are usually rated sub investment grade. GLOBAL LOANS Debt investments which are collateralised by assets such as property mortgages or public sector loans. Securitised debt includes mortgage-backed securities (‘MBS’), asset- backed securities (‘ABS’), and commercial mortgage-backed securities (‘CMBS’) and covered bonds. SECURITISED Sovereign bonds issued by emerging market countries in their own local currencies (internal debt). EMERGING MARKET SOVEREIGN(Local) Sovereign bonds issued by emerging market countries in foreign currencies (external debt) such as US Dollars or Euros. EMERGING MARKET SOVEREIGN(Hard) Bonds issued by local authorities, supranational entities and government agencies. GOVERNMENT RELATED Investment grade corporate bonds. CORPORATE Government bonds issued by developed countries globally. GLOBAL TREASURY Treasury - Barclays Global Aggregate Global Treasury Index (hedged to USD) / Government Related - Barclays Global Aggregate Global Government Related Index (hedged to USD) / Corporate - Barclays Global Aggregate Global Corporates Index (hedged to USD) / Securitised - Barclays Global Aggregate Global Securitised Index (hedged to USD) / High Yield - Barclays Global Aggregate Global High Yield Index (hedged to USD) / Global Loans - 80% Credit Suisse Leveraged Loan Index and 20% Credit Suisse Institutional Western European Leveraged Loan Index (hedged to USD) / EM Sovereign (Hard Currency) - JP Morgan EMBI Global Diversified Index / EM Sovereign (Local Currency) - JP Morgan GBI-EM Global Diversified Traded Index 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 H1 High Yield 29.3% EM Sov(HARD) 22.2% EM Sov(LOCAL) 16.9% EM Sov(LOCAL) 23.0% 15.2% EM Sov(LOCAL) 18.1% EM Sov(LOCAL) -5.2% EM Sov(LOCAL) 15.7% EM Sov(LOCAL) -1.8% EM Sov(LOCAL) 16.8% EM Sov(LOCAL) -9.0% EM Sov(HARD) 11.6% EM Sov(HARD) 10.2% EM Sov(HARD) 9.9% EM Sov(HARD) 6.2% EM Sov(HARD) -12.0% EM Sov(HARD) 12.2% EM Sov(HARD) 7.3% EM Sov(HARD) 17.4% EM Sov(HARD) -5.3% Corporate 3.5% Corporate 3.6% Corporate 3.2% Corporate 7.2% Corporate -5.1% Corporate 4.8% Corporate 10.9% Corporate 0.1% High Yield 12.0% High Yield 5.6% High Yield 57.7% High Yield 15.1% High Yield 3.6% High Yield 19.2% High Yield 6.5% High Yield -25.2% High Yield 2.0% High Yield 12.2% Securitised 3.2% Gov Related 2.8% Treasury 2.0% Global Loans 7.5% Global Loans 2.0% Global Loans -28.9% Global Loans 1.3% Global Loans 9.7% Global Loans 6.7% Securitised 4.9% Securitised 3.2% Securitised 4.4% Securitised 5.7% Securitised 7.2% Securitised 5.3% Securitised 5.7% Securitised 4.6% Securitised -0.4% Gov Related 4.4% Gov Related 4.2% Gov Related 3.7% Gov Related 6.9% Gov Related 4.1% Gov Related 6.0% Gov Related -0.9% Gov Related 4.4% Treasury 4.8% Treasury 5.0% Treasury 3.3% Treasury 9.1% Treasury 1.0% Treasury 3.6% Treasury 4.5% Treasury 0.1% Treasury 5.6% Treasury 5.5% EM Sov(HARD) 29.8% Securitised 5.8% Global Loans 11.0% Global Loans 5.7% Global Loans 5.9% Global Loans 45.4% Global Loans 9.8% Gov Related 6.1% Gov Related 5.3% EM Sov(LOCAL) 6.3% EM Sov(LOCAL) 22.0% Corporate 6.5% Corporate 5.5% Corporate 16.6% High Yield 6.1% Treasury 3.8% EM Sov(HARD) 8.7% Securitised 3.9% Global Loans 2.6% Gov Related 4.2% EM Sov(LOCAL) 6.0% Corporate 5.1% EM Sov(LOCAL) ANNUALRETURNS(%)ANNUALRETURNS(%)
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