Why global credit should be part of a fixed-income investment

Global credit, with its historically high yields, should feature in any fixed-income investment, writes Matthew McCrum.

Fixed-income investing is not what it used to be. The purge of toxic assets throughout 2009 has cast new light on what is considered safe, and sparked a re-think about how to limit the downside risks for fixed-income investors.

Investing in defensive assets should be based on capturing the upside beta while controlling the downside risk — the so-called asymmetric returns.

During the heady pre-global financial crisis (GFC) days of 2006-07, as the global appetite for increasingly leveraged versions of fixed-income securities took root, many investors began avoiding traditional fixed interest investments as unfashionable.

Boring beta.

Such investors subsequently shrank their holdings in investment grade securities in favour of structured credit, mortgage-backed securities and various exotic derivations.

While chasing attractive returns through increased leverage, investors took on greater commensurate levels of risk — to their ultimate detriment. As we know, risk did not pay off during 2008-09.

The upshot is that many investors have had no part of their portfolio generating positive returns throughout this period, and those who hired portfolio managers who took them into higher risk assets have — either through inertia or liquidity issues — toughed things out with their underperforming managers.

In defensive investing, global credit has seen the biggest underperformance through poorly managed risk (closely followed by Australian fixed interest and global government debt).

So where has this left investors? Has the defensive investing baby been tossed out with the bath water?

It would be a shame if this were the case, because there remains much value in global credit — it has high yields over government bonds, for example.

Other benefits include global credit’s effective protection against inflation, while investors can avoid the mistakes of the past by taking on less risk.

But there is a better way. In our view, investors should look for more efficient risk through better management of certain securities in the index.

Global credit spreads have risen and then rallied dramatically over the past year, with many investors wondering if there is still value in credit.

Investors in credit markets are still being rewarded for risks that are not credible under most economic scenarios.

Credit spreads are pricing in default rates three times higher than the great depression.

The benefits for investing in global credit for investors are the increased yield over government bonds for increased diversification when compared to their local market. Global credit also provides some protection from interest rate rises that will negatively affect bonds.

Advantages of investing in credit

Investing in credit has four advantages for investors:

1. There is a yield over government bonds, which compensates investors for default risk;
2. Credit risk that is being priced in is far greater than most credible economic scenarios;
3. Credit has lower volatility than equities and provides diversification against an increase in interest rates; and
4. Credit as a hedge against inflation. The relationship between credit spreads and the overall health of the economy means that credit is a good hedge against inflation.

Investors in credit receive a yield above government bonds to compensate them for the extra risk associated in investing in corporations that have the possibility of not repaying their debt.

This possibility of default risk is and has been very low; the long-term average is less than 1 per cent of corporations defaulting in a single year.

Credit markets are forward looking and price in the probability of future defaults. With the onset of the GFC in 2008 credit markets reacted by credit spreads moving from historically tight levels through to unprecedented high levels.

Chart 1 shows that until recently credit spreads have never reached more than 3 per cent in the US. Historically, each peak in credit spreads has occurred during periods of heightened risk of default.

In the early 90s it was a recession, 1998 was long-term capital management and 2001-02 was the bankruptcy of Enron and WorldCom — with the most recent crisis beginning in mid-2007 and peaking in November 2008.

As in 2009, immediately after each of these shocks credit markets have rallied dramatically. The main question with the current market is — how far will the credit market rally?

How can investors get exposure to credit?

Traditional active management

Investors have had limited choices for getting exposure in global credit. The first, traditional active management, has had poor results with many managers underperforming dramatically in recent times.

Chart 2 shows the poor performance of global credit managers in times when credit underperforms.

This is largely due to managers taking extra risk outside the benchmark universe, such as investment in sub-investment grade and structured credit, rather than demonstrating a skill in security selection from within the universe.

Index management

Fixed interest markets are mostly efficient.

However this is not translated into the composition of credit benchmarks and index funds, with fixed interest benchmarks inefficiently constructed. Benchmarks, and the index funds that track them, are inefficiently constructed as:

• They are weighted to organisations that borrow more: The way fixed interest benchmarks and index funds are constructed means they give higher weighting to issuers that have the most amount of debt outstanding, irrespective of financial health of the issuer. This also means that sectors that have a lot of debt outstanding also have higher weights in a benchmark than those issuers and sectors that don’t require as much debt. For example, the Barclays Capital Global Aggregate Bond: Corporates Index currently has a weighting of 54.05 per cent in financials at a time when investing in financials is being seriously questioned (see Table 1).
• The default credit analysis is rating agencies — one of the major lessons in a post-GFC world is investors cannot rely solely on credit ratings agencies as a means for assessing the credit worthiness of an organisation.
• There is no weighting to liquidity — fixed interest markets are an over-the-counter market, which means that published data for liquidity is hard to readily obtain. Indexes use a single dimension rule of the amount outstanding in an issue to assess liquidity. This blanket rule means that many issues included in the benchmark can’t be readily purchased.

An alternative

The alternative to gain an efficient exposure to credit is very straightforward:

Invest in a highly diversified manner.

Rather than letting benchmarks dictate security weights or taking concentrated bets, setting low issuer constraints can lead to a more highly diversified portfolio which limits the impact of any one specific issuer default or downgrade.

Invest in organisations that exhibit a superior financial health footprint.

Rather than have portfolios dominated by issuers who simply issue more debt, or taking puts on sub-investment grade or exotic securities, invest in issuers who are more financially healthy than their peers.

The financial health footprint of issuers can be readily measured on the profitability, liquidity, solvency and indebtedness of an issuer against their global sector peers to determine which issuers are the most financially healthy.

Invest in a risk-controlled manner that targets low volatility.

Since investors use indexes in asset allocation, outright volatility is more important than relative tracking error.

Conclusion

The reward for investing in credit in a diversified manner outweighs any historical risk — and most credible economic forecasts.

With the current market pricing default rates three times greater than the Great Depression, the reward for investing in credit is high — even after a dramatic rally in credit.

With many managers underperforming in recent times due to taking risk from outside the benchmark, there is an alternative for investors.

Investors need to be exposed to corporate securities from organisations that are the healthiest available, and through investing in such a strategy investors can capture the high historical yield and manage the downside risk.

Mathew McCrum is director of investments at Omega Global Investors.