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Credit markets: tough to love, tough to hate
Nicholas Ware, fixed income portfolio manager, considers the love-hate relationship towards credit markets, arguing that near-term political and economic uncertainty supports the case for investing in corporate bonds from issuers that offer ‘sensible income’.
Sep 25, 2024
6 minute watch
6 minute watch
Key takeaways:
- Credit spreads are tight (tough to love), but valuations are arguably justified by strong credit fundamentals (tough to hate) and reasonably attractive yields.
- We are seeing a tailwind for credit from fund inflows into the asset class as investors look to lock in yields, while caution by companies over recent years means many companies have fewer financial vulnerabilities in the face of an economic slowdown.
- In our view, investors can capture the returns on offer from corporate bonds by investing in ‘sensible income’, i.e. bonds from corporate issuers that are less cyclical, with predictable cash flows and strong financial health.
IMPORTANT INFORMATION
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
There is no guarantee that past trends will continue, or forecasts will be realised. Past performance does not predict future returns. Yields may vary over time and are not guaranteed.
Definitions
Barbell: An investment strategy that advocates investing in a mix of assets with opposing characteristics.
Carry: The benefit or cost of holding an asset, including any interest paid, the cost of financing the investment, and potential gains or losses from currency changes. It can also be used to describe income on a bond.
Cash flow: The net amount of cash and cash equivalents transferred in and out of a company.
Corporate bond: A bond issued by a company. Bonds offer a return to investors in the form of periodic payments and the eventual return of the original money invested at issue on the maturity date.
Coupon: A regular interest payment that is paid on a bond, described as a percentage of the face value of an investment. For example, if a bond has a face value of $100 and a 5% annual coupon, the bond will pay $5 a year in interest.
Credit is typically defined as an agreement between a lender and a borrower. It is often used to describe corporate borrowings, which can take the form of corporate bonds, loans or other fixed income asset classes.
Credit fundamentals: The basic qualitative and quantitative information that reflects the company’s financial and economic position, for example, its earnings, ability to generate cash, management quality and levels of debt.
Credit rating: A score given by a credit rating agency such as S&P Global Ratings, Moody’s and Fitch on the creditworthiness of a borrower. For example, S&P ranks investment grade bonds from the highest AAA down to BBB and high yields bonds from BB through B down to CCC in terms of declining quality and greater risk, i.e. CCC rated borrowers carry a greater risk of default.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing (tightening) indicate improving.
Cyclical: Companies or industries that are highly sensitive to changes in the economy, such that revenues generally are higher in periods of economic prosperity and expansion and are lower in periods of economic downturn and contraction.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Duration: the sensitivity of a bond’s price to a change in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa. Bond prices fall when yields rise and vice versa.
High yield: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings.
Issuance: The act of making bonds available to investors by the borrowing (issuing) company, typically through the sale of bonds to the public or financial institutions.
Landing: A hard landing is where the economy contracts sharply. A soft landing is a moderate slowdown in the economy in response to a controlled reduction in inflation.
Leverage: Another term for indebtedness e.g., a company with high leverage would have high debt levels relative to earnings.
Maturity: The maturity date of a bond is the date when the principal investment (and any final coupon) is paid to investors. Shorter-dated bonds generally mature within 5 years, medium-term bonds within 5 to 10 years, and longer-dated bonds after 10+ years. the sensitivity of a bond’s price to a change in interest rates.
M&A: Mergers & Acquisitions. Companies merging with or acquiring other companies. Large acquisitions are often financed by debt.
Sovereign bond: A bond issued by a country, another term for a government bond.
Total return: The return on an investment taking into account both income and any change in capital value.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.
Yield: The level of income on a security, typically expressed as a percentage rate. For a bond, at its most simple, this is calculated as the annual coupon payment divided by the current bond price.
Carry: The benefit or cost of holding an asset, including any interest paid, the cost of financing the investment, and potential gains or losses from currency changes. It can also be used to describe income on a bond.
Cash flow: The net amount of cash and cash equivalents transferred in and out of a company.
Corporate bond: A bond issued by a company. Bonds offer a return to investors in the form of periodic payments and the eventual return of the original money invested at issue on the maturity date.
Coupon: A regular interest payment that is paid on a bond, described as a percentage of the face value of an investment. For example, if a bond has a face value of $100 and a 5% annual coupon, the bond will pay $5 a year in interest.
Credit is typically defined as an agreement between a lender and a borrower. It is often used to describe corporate borrowings, which can take the form of corporate bonds, loans or other fixed income asset classes.
Credit fundamentals: The basic qualitative and quantitative information that reflects the company’s financial and economic position, for example, its earnings, ability to generate cash, management quality and levels of debt.
Credit rating: A score given by a credit rating agency such as S&P Global Ratings, Moody’s and Fitch on the creditworthiness of a borrower. For example, S&P ranks investment grade bonds from the highest AAA down to BBB and high yields bonds from BB through B down to CCC in terms of declining quality and greater risk, i.e. CCC rated borrowers carry a greater risk of default.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing (tightening) indicate improving.
Cyclical: Companies or industries that are highly sensitive to changes in the economy, such that revenues generally are higher in periods of economic prosperity and expansion and are lower in periods of economic downturn and contraction.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Duration: the sensitivity of a bond’s price to a change in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa. Bond prices fall when yields rise and vice versa.
High yield: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings.
Issuance: The act of making bonds available to investors by the borrowing (issuing) company, typically through the sale of bonds to the public or financial institutions.
Landing: A hard landing is where the economy contracts sharply. A soft landing is a moderate slowdown in the economy in response to a controlled reduction in inflation.
Leverage: Another term for indebtedness e.g., a company with high leverage would have high debt levels relative to earnings.
Maturity: The maturity date of a bond is the date when the principal investment (and any final coupon) is paid to investors. Shorter-dated bonds generally mature within 5 years, medium-term bonds within 5 to 10 years, and longer-dated bonds after 10+ years. the sensitivity of a bond’s price to a change in interest rates.
M&A: Mergers & Acquisitions. Companies merging with or acquiring other companies. Large acquisitions are often financed by debt.
Sovereign bond: A bond issued by a country, another term for a government bond.
Total return: The return on an investment taking into account both income and any change in capital value.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.
Yield: The level of income on a security, typically expressed as a percentage rate. For a bond, at its most simple, this is calculated as the annual coupon payment divided by the current bond price.
Yields quoted are the yield on the ICE BofA US Corporate Index, which reflects US dollar denominated investment grade corporate debt publicly issued in the US domestic market, and the yield on the ICE BofA US High Yield Index, which reflects US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Yields as at 24 September 2024, sourced from Bloomberg. Yields may vary over time and are not guaranteed.
JHI
JHI
View transcript
Nicholas Ware: A quick video on Credit – I would frame the market at the moment as an asset class that is tough to love, but equally it’s tough to hate.
Why do I say it is tough to love? Because credit spreads are historically tight. By that I mean the additional yield they pay over government bonds of the same maturity is currently at the low end of their historical range.
But good corporate fundamentals i.e. the financial strength of businesses and decent borrowing metrics, mean it’s tough to hate credit.
Economies are slowing and central banks are delivering cuts. September has seen the US Federal Reserve join other major central banks in cutting rates.
For credit, what matters more is whether the growth data is holding up…so it is still a healthy environment for credit. Valuations have come in a lot and are pricing in a soft landing. I think the market will stay unpredictable and bumpy for a while as the soft versus hard landing debate continues.
In our view, economic uncertainty underscores a need not to chase beta or lower quality companies, with our preference firmly towards reliable sensible income investments.
The credit market has performed well year to date with the benefit of carry – coupon income – providing a decent return. 2024 has been a range bound market, albeit with some bumps along the way.
There were three economic or political events which caused a sell-off during the year. These quickly reversed as the dip was bought. In April, Israel-Palestine, in June, France’s snap election and in August, weak US employment data.
I think whilst spreads look tight the all-in yield proposition still holds. While yields are not as enticing as they were a year ago, average yields on US IG [investment grade] of close to 5% and US high yield close to 7% are likely to appeal to investors as interest rates decline. We are seeing a nice tailwind for credit markets from fund inflows too as investors want to lock in yields.
The first week in September saw the fifth largest issuance week ever in US investment grade, with demand from investors comfortably absorbing this.
In terms of outlook, I think we will see some modest spread widening in Q4. In fact, we are already seeing some spread widening during September. I think this is logical as investors are pricing in growth concerns and also US election volatility.
But ultimately, into year end, I think with you will end with a positive total return, with the benefit of carry outweighing any spread widening in both investment grade and high yield.
We have passed through Q2 earnings season which looked fine and leverage metrics still look robust in the US and in Europe for investment grade, with some weakening in high yield.
We are seeing weakness in European auto company bonds following a BMW profit warning, together with weakness from companies exposed to low end consumers, including certain retailers and restaurants.
However, the reason we like credit is that companies through this cycle have been cautious. This is reflected in business surveys which are showing a worse picture than the actual hard data has shown through this business cycle post the COVID outbreak. Essentially, business managers have been more downbeat than is warranted by their company performance.
We have seen no build-up of leverage, large M&A or over-expansion through this cycle. Hence, most of the public credit markets are coming into the slowdown relatively clean, with no obvious vulnerabilities.
We believe our strategy of buying sensible income makes sense here given this backdrop.
What do we mean by sensible income?
Sensible income is a mantra that we use to define us on the desk.
We avoid lending money to certain industries because of inherent cyclicality such as autos and airlines. Plus their inability to generate a good free cashflow return on investment over time.
Let me give you an example of what we perceive is a sensible income company.
Iron Mountain is a US high yield bond issuer, rated BB-. It is a storage and data centre business with a US equity listing. It has managed the transition from just being a document storage business with low organic growth into a combined data storage and document storage business with good organic growth.
In this analysis, we believe that factors such as business risk, the predictability of cash flow, asset protection, and the overall financial health of the company merit a higher quality credit rating. The positive trajectory of Iron Mountain’s fundamentals are gaining more recognition in the equity market than amongst the credit rating agencies.
Like back in August, today the market is closely examining clues about whether we are heading for a soft or hard landing. I think, these periods will cause volatility and presents us with opportunities.
We like Investment grade in the 3-5 year range and the 7-10 year maturity range as well and also BB rated high yield.
We think a barbell of lower duration sensible credit exposure and taking long duration via sovereign exposure makes sense here given the macro backdrop.
Related insights
Sep 25, 2024
6 minute watch
6 minute watch
Key takeaways:
- Credit spreads are tight (tough to love), but valuations are arguably justified by strong credit fundamentals (tough to hate) and reasonably attractive yields.
- We are seeing a tailwind for credit from fund inflows into the asset class as investors look to lock in yields, while caution by companies over recent years means many companies have fewer financial vulnerabilities in the face of an economic slowdown.
- In our view, investors can capture the returns on offer from corporate bonds by investing in ‘sensible income’, i.e. bonds from corporate issuers that are less cyclical, with predictable cash flows and strong financial health.