This is the end of the credit cycle
20 April 2020 | Markets and Economy
A comment from Sarang Kulkarni, portfolio manager for investment grade credit.
The Covid-19 pandemic has sent shockwaves through financial markets. Volatility has risen markedly; a rush to safe assets has tested the liquidity of even the US Treasury market; and efforts to limit the spread of the virus look likely to push the global economy into a sharp recession.
Given the magnitude of the shock and the negative impact it will have on corporate earnings, many investors are questioning the impact this could have on corporate debt markets.
So what does the coronavirus crisis mean for investors in credit?
An abrupt end to the expansion
For one, it means the current credit cycle has come to an end.
The coronavirus pandemic struck just as we were approaching the end of an extended credit cycle. With valuations already stretched, even a minor economic upset would have been enough to tip markets into correction territory. And the coronavirus crisis has undoubtedly delivered a substantial enough blow to bring an abrupt end to the economic expansion in most countries.
Despite the unique nature of the coronavirus shock, what we are seeing in markets at the moment is nothing new. In fact, we expect the credit cycle to continue to revolve much as it has over the past 30 years, with the four phases of expansion, slowdown, recession and recovery repeating over time.
The coronavirus crisis has brought us very rapidly through the slowdown phase into the recession phase. Consequently, volatility spiked in March and there was a significant tightening of market liquidity, causing the spreads on all credit bonds to widen indiscriminately.
As a result, valuations have now become much more attractive. Credit spreads have quickly gone from historically rich to historically cheap levels. Whenever they have become this wide in the past, investors in credit have usually been rewarded with higher-than-normal positive excess returns.
While we remain in the recession phase, there remains the risk that spreads could potentially widen even further; but with central banks implementing credit purchase programmes, markets should be well supported.
However, this is also when the underlying fundamentals of companies come to the fore. During a recession, most companies see their earnings contract, many experience credit ratings downgrades and some default on their debts. Fundamentals, which are currently weak, are likely to deteriorate further as the recession phase starts to bite.
The investment-grade credit market often undergoes a bifurcation during recessions. The companies best-equipped to weather a recession tend to be those with strong balance sheets, adequate capital and robust liquidity. Firms without these resources are more likely to find themselves permanently impaired as a result of the current crisis and are the most at risk from ratings downgrades.
So as strong companies get stronger and the weak get even weaker, it's especially important to be selective in credit during a recession, investing in high-quality issuers.
Looking ahead to the recovery
After the recession comes the recovery phase. Central banks, which have already slashed base rates and purchased record amounts of assets to bolster economies in response to the crisis, will probably remain accommodative to fuel the recovery. Companies, meanwhile, typically reduce dividends and share buybacks and cut back on their growth plans.
As a result, high-grade credit tends to outperform equities (on a risk-adjusted basis) once the recovery takes hold as corporate bonds emerge as the most attractive source of income.
Given the willingness of policymakers to stimulate growth and the historically attractive valuations, it's a potentially rewarding time for investors in credit.
The importance of credit research
There is an important caveat, however. As we have seen, the distinction between different credit qualities becomes more pronounced during downturns. With some estimates for 2021 global high-yield defaults approaching 10%-15%1, credit quality has the potential to be a crucial driver of performance.
It's therefore critical to be able to identify the stronger companies, and credit research is key to taking true advantage of the dislocated spreads we are witnessing at the moment. While most cyclical sectors are at risk, we see opportunities for the stronger companies in these sectors to take advantage of the reduced competition to consolidate their market share and earnings.
Investors in credit also need to be patient. While the case for credit is strong, it's difficult to tell how long the different phases of the cycle could last. They must not lose sight of why they invest in fixed income credit, which for most investors will be for diversification, risk-adjusted returns, income and liquidity.
High-grade corporate credit can play a valuable role in complementing traditional fixed income allocations, such as government bonds, in a portfolio. With valuations at such attractive levels, selectively allocating to high-quality credit can provide investors with a source of income and strong risk-adjusted returns while also offering defensive qualities compared with equities.
Above all, they should keep their investment costs low. High fees, especially over long time horizons, can eat into investment returns. And in the context of active funds, the higher the fees, the more risk a manager might be tempted to take on to try to achieve excess returns net of fees.
1 Source: Moody's “February 2020 Default Report”
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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