Amid persistently volatile and unpredictable equity markets, we believe income will need to play an outsized role in investors’ returns this year – and dynamic credit exposure may be a compelling way for investors to de-risk their portfolios without sacrificing potential yield.
A flexible investment approach is critical during volatile markets, and multi-asset credit strategies that can pivot to the most attractive opportunities may offer some key advantages. The greater dispersion between credits we’re seeing today calls for thoughtful bottom-up security selection to tap select opportunities.
Our Global Opportunistic Credit strategy seeks to position portfolios for potential bouts of volatility and through market cycles. The strategy finds relative value by investing in components of US leveraged finance – high yield, bank loans, and collateralized loan obligations (CLOs) – then, to varying degrees, across geographies and the risk spectrum. This strategy allows investors to tilt the portfolio toward areas that may provide the best opportunities – through asset allocation, tactical opportunities, and security selection – while managing the risks ahead.
Markets have been rattled by recent banking jitters on the heels of a highly unusual year in 2022, when credit spreads widened even as rates rose and equities dropped, defying the usual correlations and historical norms. This was largely a result of equalization after markets overshot and interest rates came off unsustainable pandemic-era lows – conditions that are unlikely to be replicated.
Today, we’re playing defense in Global Opportunistic Credit amid widespread and persistent inflation, increasing geopolitical and macro risks, and interest rate hikes from the Fed and central banks globally. A key question in this environment is how to intelligently de-risk the portfolio without sacrificing yield. And when we consider the critical income component of returns, we must be vigilant about preserving that advantage.
To this end, when moving among asset classes, we favor tactically rising up the capital stack into investment grade CLO tranches, which offer a decent trade-off with lower-rated leveraged loans as well as yield pickup compared to similarly rated investment grade and high yield bonds and leveraged loans.
Source: JP Morgan, Bloomberg, as of 31 March 2023. For illustrative purposes only. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change
Amid the Federal Reserve’s inflation-fighting rate-hike regime, we have maintained a preference for floating-rate bank loans and CLOs over fixed-rate high yield bonds since the second half of 2022, as floating-rate assets provide protection against rising rates. However, the value proposition between fixed and floating-rate assets has tilted back toward neutral with the recent market volatility.
While loans continue to have a meaningful yield advantage due to the current rates curve, the spread differential between loans and high yield has compressed, resulting in our more neutral stance. In addition, we believe the Fed is nearing the end of the rate-hike cycle, which diminishes the value of interest rate protection provided by floating-rate assets. The high yield market in particular may also offer a benefit that many investors may be overlooking: the discount in terms of the average price relative to par. Historically, during periods like today when the weighted average price for the high yield market offered a significant discount to par – e.g., at the end of 2008/early 2009, February 2016, and March 2020 – we have seen attractive entry points to add to the asset class.
All told, a mix of fixed and floating-rate assets works well from a portfolio diversification standpoint – and many investors remain underexposed to floating-rate assets.
From a sector perspective, we still favor an overweight to energy and communications, including cable TV, as well as cruise lines and other areas such as pockets of gaming where we view assets as underpriced.
While we currently do not see big differences between opportunities in the developed markets, we believe the ability to allocate tactically among different regions to seek opportunistic investments is beneficial during dislocations.
Source: Bloomberg, based on the Bloomberg US Corporate High Yield Bond Index, as of 31 March 2023.
In Global Opportunistic Credit, we focus on controlling the risks we can – fundamental, issuer, credit, and default risks – while positioning to weather those we can’t (such as unexpected central bank policy moves or exogenous shocks, like wars or pandemics).
The main risk, in our view, is a potential rise in volatility stemming from equities, which would likely hit credit spreads given the high historical correlations between these markets – particularly equities and high yield. Our base case is that a recession is likely, especially given the recent troubles in parts of the banking sector and the fall-on effects from tighter lending and monetary policy tightening. That said, we don’t expect the downturn to be severe.
Despite the recession risk, we are not overly concerned about credit defaults and are generally aligned with what markets are currently pricing in.
In US high yield, we expect default rates to increase over the next 12 to 24 months, but only toward historical averages of 2.5%-3.5%, as opposed to the 6%-8% default rates that might be seen in a more severe recession. We view current valuation spreads as reflective of such an outcome overall. Moreover, high yield defaults historically have been concentrated in the CCC bucket (see chart), which has shrunk in size.
Source: BofA Global Research, High Yield Credit Chartbook, as of 31 March 2023.
Companies have reduced debt, with high yield issuers’ overall leverage improving in recent years (see charts). Credit quality has also improved for high yield bonds as companies’ cash flows recover from pandemic-driven declines.
Source: BofA Global Research, High Yield Credit Chartbook, as of 31 March 2023.
In leveraged loans, notwithstanding a minor uptick in defaults in the second half of 2022, defaults remain historically low at just 0.72% by amount outstanding and 0.68% by issuer count (see chart). That said, with interest coverage ratios likely to be tested, rating downgrades set to outpace upgrades, and a greater percentage of the market trading at discounted levels, we expect default rates to rise over the coming year. Yet defaults would need to move much higher, exceeding the long-term historical average of 2.7%, to really hurt the broader market.
Source: Pitchbook LCD based on the Morningstar LSTA Leveraged Loan Index. Data as of 31 March 2023.
Rising interest costs are front of mind for leveraged loan investors, as cash flows for select issuers, including those with largely unhedged floating-rate structures, may come under pressure. The percentage of the loan market trading at distressed levels (i.e., loans trading below 80) stood at roughly 5.4% at the end of February 2023, down from the recent peak of 7.4% during fourth-quarter 2022 but still well above the monthly average of 2.4% over the course of 2021-2022.
Source: Morningstar LSTA Leveraged Loan Index Factsheet as of 31 March 2023.
Despite these uncertainties and the expectations of higher defaults, loan issuers have benefited from several years of strong revenue and earnings growth, and even in a low growth or moderately contracting environment, issuers are starting from a position of strength and have some cushion to deal with increased volatility.
More broadly, credit’s strong starting position should help offset potential risks.
Flexibility to ride out volatility is more important than ever, and multi-asset credit strategies with the ability to move up and down the capital stack, across asset classes, and across regions – without giving up much, if any, yield – may look attractive to investors seeking the best opportunities to maximize returns outside of equities.
For illustrative purposes only. Any views represent the opinion of the investment manager and are subject to change. There can be no assurance that any investment objective or target will be achieved.
There’s little question that volatility will persist in 2023. And with many investors still underinvested in credit after years of low yields and an anomalous year in 2022 (when equities and bonds declined in tandem), we believe it’s a good time to reassess the benefits of a flexible credit solution to provide income and help meet return targets. Implementing a multi-asset credit strategy begins with selecting a manager with a depth of experience managing through credit cycles, strong research and portfolio execution capabilities, and product offerings that can adjust to meet investors’ return objectives and risk appetite.
We believe Global Opportunistic Credit can offer investors a nimble way to tap the benefits of credit in any environment – even a tough and unpredictable backdrop like we’re seeing today.
To learn more, visit PineBridge’s Global Opportunistic Credit page.
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any republication of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.