The views expressed are those of the authors at the date of publication and are subject to change. Other teams may hold different views and make different investment decisions. Forward-looking statements should not be considered as guarantees or predictions of future events. The value of your investment may become worth more or less than at the time of original investment. For professional or institutional investors only. Please refer to any investment risks noted at the end of the content.
Amar Reganti: As the COVID-19 situation evolves, many allocators have been asking for ideas about how to exploit the recent market dislocations. In credit, we’ve seen dramatic widening in spreads, to levels that historically have represented an attractive entry point, particularly if the worst of the crisis is behind us. Importantly, we also find that implied default rates for many credit instruments are well above those we expect to be realized. Furthermore, as we’ve seen in the past, there’s the potential for credit to mean revert faster than equities. We believe that the lower volatility and risk profile of credit relative to equities may offer a higher risk-adjusted return across a range of potential economic outcomes.
As investors evaluate credit opportunities, there are a few risks to consider. First, a prolonged downturn could create further stress for borrowers. We are also, to some degree, relying on government support for issuers as well as for market liquidity. Finally, there’s the potential for rising interest rates to throw a wrinkle into returns over time.
With that backdrop in mind, let’s discuss what’s happening on the ground in the credit environment with multi-sector credit investor Campe Goodman.
Campe, can you start with an overview of how you approach multi-sector credit investing?
Campe Goodman: Our approach to investing in the multi-sector credit opportunity set focuses mainly on higher-yielding sectors, including corporate bonds, bank loans, emerging markets, and structured finance. We emphasize these segments of the market because we think they can provide the potential for equity-like returns with about half the volatility of equities. Importantly, you never know where the value is going to come from, whether it’s in corporates, emerging markets, or loans. We therefore think it is crucial to be able to rotate across those segments to seek to add value.
Our approach to this opportunity set is two pronged. First, we look at these market segments from a top-down standpoint and project returns for each of them. We try to identify the segments we think are going to have the best returns for the amount of risk we’re taking. Second, we work closely with our sector specialists to help find the most attractive opportunities within each sector of the market.
Amid the current crisis, what’s changed in your outlook on the credit opportunity set?
Campe Goodman: In general, our view is that credit is on sale right now. We think it is attractively valued, and historically spreads have been wider than they are today only about 10% – 20% of the time. Even though spreads have compressed from their peaks, they are still wide relative to their historical averages. And historically, when high-yield bond spreads have been around these levels, the annual three-year return has been about 5% greater than Treasuries.1 We think this is a time to think hard about buying, because there’s a lot of negative news already priced into spread assets. But you still need to be selective. We believe you don’t have to buy at the very bottom for this to still be an attractive opportunity.
For example, we find developed market corporate debt compelling. So high yield and bank loans both look quite attractive to us right now. We’re also finding interesting opportunities in emerging markets corporate bonds, a number of which have experienced drastic spread widening. In addition, we see some opportunities in convertible bonds, which may provide good downside mitigation if we have more volatility. But convertibles also can participate on the upside if equity markets continue to rebound. In addition, they may provide access to different issuers than the standard high-yield bond market. Convertible bonds tend to be focused more on technology and health care, two sectors that may provide investors some diversification.
How are you thinking about the relative attractiveness of corporate credit versus structured credit today?
Campe Goodman: Speaking again at a very high level, we currently prefer corporate credit over structured credit. It’s true that certain areas of structured credit have been marked down pretty severely, but we think that, in some cases, that is warranted. Looking forward, we think the environment is still going to be quite rocky and it really depends on which structured credit you’re evaluating. In the mezzanine areas of structured credit, there may be extremely high yields, but the outcomes are likely to be quite binary. So, if we have a second wave of the virus later this year and we have to shut down the economy again, we think that’s really going to be very hard for a lot of structured finance securities. Structured finance has exposure to areas like retail and hotels, which are likely going to be challenged. In our view, the outcomes in corporate credit are going to be less binary and potentially still very attractive. Higher up in the capital structure, I’d say there are areas of structured credit that are attractive, including a lot of the AAA securities in commercial mortgage-backed securities. For more conservative investors, those areas may be worth considering.
From your multi-sector perspective, what is your current view on emerging markets sovereign bonds?
Campe Goodman: I think high-yield emerging markets look relatively attractive and there’s a lot of bad news already priced in. Higher-quality emerging markets, on the other hand, do not look as attractive. I don’t believe they are sufficiently priced for the possibility that the COVID-19 crisis really spreads and that a number of emerging markets are not well equipped to handle it.
Finally, how should investors think about the mix between investment grade and high yield today?
Campe Goodman: On high yield versus investment grade, I’d say that is going to be a question of how much risk investors are looking to take. Right now, I think high yield is attractively valued. Until recently, there were a lot of investment-grade issues at very attractive levels. But the prospects of US Federal Reserve purchases and fiscal support have already contributed to significant tightening of investment-grade spreads. I think they’re not as attractive right now. So, even on a risk-adjusted basis, I prefer high yield.
1 Source: Barclays, Wellington, as of 31 May 2020. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE. Indices are unmanaged and cannot be invested in directly.
- Emerging markets risks
- Credit risk
- Fixed income securities market risks
- Liquidity risk
- Interest-rate risk
- Below investment grade risks
- Risks of derivative instruments
- Currency risk
- Issuer-specific risk
- Leverage risk
- Repo and reverse-repo risk
For professional, institutional, and accredited investors only. The views expressed are those of the author, are given in the context of the investment objective of the portfolio, and are subject to change. Other teams may hold different views and make different investment decisions. This material and its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. While any third-party data used is considered reliable, its accuracy is not guaranteed. Forward-looking statements should not be considered as guarantees or predictions of future events. Past results are not a reliable indicator or future results. This commentary is provided for informational purposes only and should not be viewed as a current or past recommendation and is not intended to constitute investment advice or an offer to sell or the solicitation of an offer to purchase shares or other securities. Holdings vary and there is no guarantee that a portfolio has held, or will continue to hold, any of the securities listed. Wellington assumes no duty to update any information in this material in the event that such information changes. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.