Fundamentals stretched in corporate credit
Investors piling into credit markets globally have also started to raise some questions about current valuations. Yields for European high-yield credit dropped to under 2.5% earlier in early November3, while US corporate bond issuance continues to reach $1 trillion for the eight year running as borrowers take advantage of stellar demand4
But we think that investors need to be cautious. Low yields and a record high issuance of covenant-lite credits have led to potentially weaker credits flooding the market. As of September 30, 72.9% of all US leveraged loans outstanding featured a covenant-lite structure, a record high, according to the S&P Leveraged Loan Index.
There have been recent signs of a change in the broader backdrop in November. High yield is heading towards its worst month since January 2016. Markets have shifted from an extremely low level of volatility to greater dispersion among underlying credits. Significant weakness in certain sectors such as retail and healthcare have been partially masked by overall index moves by stronger sectors such as financials. The recent earnings season has been one of the most volatile quarters seen in a long time, with investors punishing companies who miss earnings even marginally. The question is whether this pick up in volatility is just a healthy and temporary correction, or whether the credit markets are finally beginning to roll over.
Diverse and defensive
In today’s uncertain credit environment, we believe in maintaining flexible exposures in credit and limiting duration risk. Long/short credit strategies by sheer nature tend to run with lower levels of duration in a fixed income portfolio, for example, sub-three year average duration or lower.
We also believe in investing across a broad range of credit markets, such as corporate credit, structured credit (pools of loans and contacts such as mortgages) and emerging market fixed income. A diverse range of credit strategies benefits during times of market weakness. For example, in Q1 2016, when high yield declined by over -7%, we found emerging market fixed income a source of alpha and performance generation. In Q4 2016 and Q1 2017, when the Barclays Global Aggregate Bond Index sold off due to reflation concerns, structured credit performed well.
As the Fed continues to tighten and many parts of the fixed income market look conspicuously expensive, we see reason to be positioned at the lower end of the risk spectrum.
