Every segment of fixed income was affected by COVID-19 and the oil price shocks in March. While U.S. government bonds benefited from rate cuts and a flight to safety, corporate, securitized and emerging markets debt all suffered amid risk aversion, forced selling and poor liquidity. Government intervention helped stabilize markets in April, though credit spreads remained wide as fundamental concerns on consumers and corporates rose.
While valuation is just one angle at which to assess investment potential, we believe several pockets of fixed income are providing compelling risk-adjusted returns today. We offer a brief look into four themes we believe will help allocators form more resilient fixed-income portfolios.
We have spoken about the value of diversification in the past, focusing on borrower type (consumer, corporate or country), place in the capital structure and asset type (e.g., real asset, corporate). While this can require specialist manager implementation and more dynamic portfolio management, we have found diversified alternative credit portfolios to be better equipped to not only weather potential storms but also capture opportunities across the credit landscape in more targeted ways.
Over 85% of securitized credit funds underperformed the index in March2. Spreads remain wider across most sectors apart from higher-quality segments that are being supported by the Federal Reserve. We believe this creates opportunities for skilled managers to 1) participate in government focus areas (such as TALF 2.0, a Fed lending program to support new issuance of asset-backed securities [ABS]) and 2) capture discounted securities across both investment-grade ABS (offering strong returns with seniority) or high-yield ABS (for higher risk/return). While fundamentals remain uncertain, particularly on sub-prime borrowers and high-risk sectors (e.g., aircraft, retail commercial mortgage-backed securities, collateralized loan obligation [CLO] equity), we would note the relative strength of the consumer, with better household balance sheets, low mortgage rates and stricter lending practices creating healthier ABS structures versus 2008.
High-yield bonds are pricing in a significant level of defaults. While this reflects greater risks (e.g., energy, retail), spreads and dispersion remain high across the board. This lends itself to an active and concentrated approach, selecting only the best corporates while avoiding (or shorting) the riskiest, and on the other end of the spectrum, being prepared for the distressed. From a relative value standpoint, bank loans appear less attractive than high yield, driven by weakening loan quality in recent years, loan-only capital structures, greater technical outflows (and a riskier buyer base in CLOs) and less government support. Given increasing investment-grade corporate stress, the fallen angel3 opportunity set is likely to increase, creating an opportunity to capture positive price momentum around downgrades (as spreads typically overreact before and around downgrades before recovering).
We believe achieving better long-term outcomes will require a greater focus on sustainability. Given how diverse the credit landscape is, the approach to sustainability should vary too: It is no longer acceptable to utilize equity environmental, social and governance (ESG) methodologies for fixed income strategies or to assume applying screens is enough. While we have seen improvement from managers on integrating ESG more fully into their process, there is more to be done, including creating more robust engagement policies, better reporting and measuring the real-world impact in greater detail.
The tremendous government support helped markets recoup much of the negative returns of March; however, while returns have been comparable, credit spreads remain relatively wide — 55% higher than the start of the year — indicating that markets are pricing in a much more negative scenario for credit versus equities. While government programs have helped support credit markets, we feel significant opportunities to capture value remain.
Source: U.S. equities is represented by the S&P 500; U.S. high yield is represented by Bloomberg Barclays US Corp HY Index WTW as of April 30, 2020. Past performance is not indicative of future results.
While valuations look attractive, this reward does come with risks as the fundamental effects of COVID-19 on the U.S. consumer and affected sectors remain unknown, particularly within aviation, retail and commercial real estate. Low oil prices continue to put pressure on energy-related credits and oil-sensitive emerging markets countries. From a technical standpoint, sectors the Fed is directly supporting are experiencing the biggest tailwind, including investment-grade corporates, select fallen angels and high-yield ETFs, and high-quality ABS/MBS, leaving sectors that are unsupported more dislocated.
While each theme requires careful consideration and relevance with respect to an individual portfolio, each may serve as a helpful starting point with which to navigate the complexities credit markets are currently facing. We feel that tremendous value remains across corporate and securitised credit, and a diversified portfolio across corporates, securitised and emerging markets debt can allow this value to be captured appropriately. For those with the governance to do so, we believe dynamically tilting portfolios can be a powerful tool to capture additional opportunities and actively shift allocations toward the most attractive risk-adjusted returns. Accessing these opportunity sets with skilled managers and firms that are not only prepared to navigate portfolios in the short term but are also thinking about long-term strategic and sustainable investment trends should hopefully create more resilient portfolios to navigate whatever the future may hold.
1 Paycheck Protection Program Lending Facility (PPPLF) provides loans to small business to keep workers on their payroll.
2 eVestment, US Securitized manager universe performance versus the Bloomberg Barclays US Securitized index.
3 Fallen angels are bonds that were previously rated investment grade but have since been downgraded to high yield.
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