Global credit markets have transformed in the decade since the financial crisis, experiencing dramatic growth and periodic volatility. Dynamic markets continue to mean that traditional metrics such as ratings and sector type may be less informative, complicating the investment process particularly for investors who focus on timing their beta exposures to specific areas of credit (investment grade, high yield, emerging market debt, securitized credit, etc.). These kinds of directional bets on individual credit sectors may become even riskier as we enter the later stages of the credit cycle.
How can investors navigate these late-cycle credit markets? We believe an active, flexible, multi-sector approach may offer investors better long-term results by focusing on structural opportunities to generate alpha.
Three credit market challenges
A flexible approach to credit market investing has become especially important due to three major factors:
- Size: The global credit markets reached over $20 trillion at the end of 2018, up from around $13 trillion a decade ago (sources: Bank of America Merrill Lynch, J.P. Morgan, Bloomberg Barclays, PIMCO). Along with growth in traditional segments, other areas like bank capital and structured credit have become more commonplace in credit portfolios.
A growing market means more opportunities and more diverse risks that allow a multi-sector approach to best navigate the technical pressure from downgrades and potential defaults. The challenge of moving from corporate credit out into a wider credit universe is assessing the correlations of various products and sectors. Evaluating a bigger opportunity set requires large global resources, robust frameworks and advanced analytics distinct from traditional credit research.
- Changing credit risk: Many borrowers have taken advantage of an easy lending environment over the last few years to access relatively cheap financing, which may lead to distorted incentives:
- Companies with a desire to stay investment grade (IG) have been able to raise more BBB rated debt (the lowest credit rating still considered IG) – the BBB market now represents 47% of the market versus 32% in 2008 (source: Bloomberg Barclays). The goal for many of these issuers is to manage their debt level and limit their weighted average cost of capital while pursuing mergers and acquisitions and share buybacks, etc.
- The leveraged loan (bank loan) market has expanded from around $350 billion in 2008 to $1.1 trillion today, while generally shifting lower in quality – B rated securities represent 53% of the bank loan market today versus 25% in 2008 (source: J.P. Morgan). As a result, many companies have gravitated to the bank loan market, leading to issuance with less investor-friendly terms coupled with less subordination.
- The non-agency mortgage-backed securities (MBS) market remains structurally attractive, in our view, though about 95% of the market is rated below IG despite robust underlying fundamentals (source: J.P. Morgan).
With these changes, it can be a challenge for investors to draw upon historical performance, correlations and comparisons to identify opportunities. Hence, it is ever more important for investors to perform underlying credit-sensitivity analysis to identify attractive valuations and opportunities. This analysis calls for deep resources that seek to understand cash flow and convexity profiles.
- Difficulty in timing beta: Trying to “time” a single sector beta can prove challenging, especially later in the credit cycle. If we encounter a more challenging macro environment, there is increased potential of fallen angels (i.e., downgrades from IG to high yield) and more pressure on liquidity, which may add to volatility and can make it difficult for investors trying to time the beta.
Having flexibility to look across the capital structure is crucial in environments where tactical opportunities may be short-lived. This reduces the potential of being a forced seller, allows a more tailored portfolio of best ideas, and may help investors capitalize on tactical opportunities during market dislocations.
Flexible credit portfolios help withstand uncertain environments
Given late-cycle dynamics and the evolution of credit markets over the last decade, credit investors should ask, “Do I have enough flexibility in my portfolio to achieve my goals?”
For many investors, a multi-sector or broad approach to credit may best position them to benefit from these dynamics. A multi-sector approach aims to assess correlations and optimize risk factors holistically, as opposed to taking a different approach for each sector, and seeks to capitalize on structural credit market inefficiencies as well as shift in and out of credit betas tactically as valuations change. We at PIMCO believe managing credit is a human-capital-intensive area, necessitating a global credit research effort, advanced technological tools and strong analytics capabilities.
For detailed insights into our views on credit, fixed income and other asset classes, please read our latest Asset Allocation Outlook.
Sonali Pier is a portfolio manager focused on multi-sector credit and high yield. Eve Tournier is head of European credit portfolio management and lead portfolio manager for the firm’s global multi-sector credit strategies.