Why going global can unlock opportunities in active credit
Commentary by Loubna Moudanib, credit analyst in Vanguard's Fixed Income Group.
As investors continue to digest the impact of the Covid-19 pandemic on markets, one piece of good news for credit investors is that the opportunity set going forward continues to be significant.
As companies and economies rebound from the coronavirus crisis, many corporates will look to the capital markets to finance their post-Covid 19 recovery.
However, while the global credit universe offers active managers a rich and varied hunting ground, understanding the regional and structural idiosyncrasies in credit markets is key to finding the best opportunities to add value, especially at a time of such uncertainty. A robust global credit research process will be critical when central-bank support, which has buoyed credit markets for some time, loses steam.
A rich hunting ground
What draws many investors to global credit as an asset class is its wide opportunity set, which stems from the depth and variety of corporates and other issuers that make up the universe. Spanning the global credit markets of 68 countries across both developed and emerging markets, one of the key benchmark credit indices comprises tens of thousands of individual bonds1, issued by corporates and government related entities. And all these bonds also vary by a number of other characteristics, such as currency, credit quality, debt structure (senior versus subordinated debt) and maturity.
The global credit universe – by currency, country, sector and rating
Source: The global credit universe as represented by the Bloomberg Barclays Global Aggregate Credit total return index hedged USD. Data as at 1 October 2020.
This diverse universe not only offers some defensive qualities relative to equities, consistent income and strong risk-adjusted returns potential; it also contains many hundreds of instances of mispricing and credit dispersion. This presents a broad set of idiosyncratic opportunities for security selection and as active credit investors, our aim is to pick the best opportunities for our portfolio, no matter where they might present themselves.
And at the current stage of the credit cycle, understanding regional nuances between issuers, sectors and credit markets is crucial to harnessing global relative value opportunities in credit.
Understanding regional nuances
The US credit market is much larger and more diverse than the European credit market2. It offers opportunities for investors to access sectors not widely available in other regions, including greater exposure to technology and energy. Recently, we have observed many large US corporates take advantage of the low funding costs in European credit markets by issuing euro-denominated debt. This resurgence in “reverse Yankee” bond issuance (euro-denominated bonds issued by US firms) has led to a greater diversity of issuers in the European market and enhanced the diversification benefits that European investors derive from holding credit3.
Sector split comparison – US dollar- and euro-denominated credit
Source: Bloomberg Barclays Global Aggregate benchmark composition as of 1 October 2020 and Vanguard calculations. Split is measured as a percentage of total corporate credit denominated in each currency.
It also gives some cross-currency arbitrage (an opportunity to take advantage of the mispricing in different currencies) without increasing credit risk. For example, for the same fundamental credit risk, a corporate bond could be much cheaper in one given currency than in another.
But it’s not just among the blue-chip names that global credit investors can generate risk-adjusted returns. No matter which region you look at, some of the most eye-catching mispricing opportunities in global credit can arise among the smaller corporates that don’t have listed shares or are less frequent bond issuers. These lesser-known credits don’t typically receive the same level of analyst coverage as the larger names. This can create more occasions where the market consensus deviates from fundamental value.
Analysing investor behaviour
In addition to fundamentals, relative-value and bond-specific analysis, understanding market technical factors (such as different types of investors, their positioning, supply in the primary market, fund flows and central-bank support) and investor sentiment across different regions is also crucial to accessing the best idiosyncratic opportunities.
Investor preferences can change by region, sector, debt structure, maturity and rating buckets driven by different risk appetite and mandates. For example, when it comes to ratings changes with “fallen angels”, bonds which fall from investment-grade to high-yield status, some large institutional allocators that manage towards certain rating thresholds can become forced sellers of the downgraded bonds. Here, in-depth credit research is critical, because proactively avoiding fallen angels that do not price in a downgrade can aid relative performance. Equally, one can benefit from buying these bonds at very cheap prices when others are forced sellers. What’s more, bond index funds which use a sampling approach, such as Vanguard’s, can also benefit from this selective approach when it comes to downgrades.
It is also interesting to analyse the domestic versus foreign ownership in different markets4. In the European market, we note a strong home bias whereby investors have a significant preference for bonds issued by domestic issuers with which they are more familiar, creating a positive technical backdrop.
Meanwhile, central banks are playing a growing role in influencing the credit market, thanks to quantitative (QE) programmes which have been enlarged to soften the impact of the Covid-19 crisis. In the US, the Federal Reserve’s announcement in March of its plans to buy corporate bonds and corporate bond ETFs had a strong positive impact on credit markets.
Large institutional investors such as insurers and pension funds5 form the backbone of the global credit market. These tend to be long-term investors who invest in credit to hedge the liabilities on their balance sheets and provide “sticky” capital to the market. Many of these investors have increasingly transitioned from government to corporate bonds in recent years as part of their strategic asset allocation in an effort to achieve higher yields. European insurers, for example, have been increasing their allocations to investment-grade corporate credit, balancing the priorities of yield generation and duration matching, with punitive capital charges for higher-risk assets like equities and high-yield bonds.
Ultimately, credit dispersion can be explained by different factors from fundamentals to more technical drivers and it is necessary to be able to identify the various sources of mispricing to gauge if it is structural or will correct, and hence create an opportunity.
An active approach for a global market
Given the size, diversity and complexity of the credit universe, it takes a truly global, collaborative approach to tap the best opportunities and generate alpha consistently, regardless of market direction or where we are in the credit cycle. In uncertain times, this is more the case than ever. By focusing on bottom-up, thorough fundamental credit research and avoiding concentrated and correlated positions, active credit investors can better navigate all kinds of market environments and identify the technical dislocations within credit markets to potentially achieve higher returns with relatively lower risk.
At Vanguard, the primary aim of our credit research team is to find the best risk-adjusted opportunities to implement in our funds. Our investment process isn’t encumbered by regional, sectoral or specialty siloes. We make decisions globally using a ‘single-portfolio’ approach that benefits from the local expertise of our analysts.
Our global credit research team is also able to leverage Vanguard’s scale as one of the largest equity holders in many large corporates to build strong long-term relationships with company management teams. And as one of the larger providers of liquidity to the market, our scale also allows us to achieve favourable execution when buying and selling bonds. Vanguard’s expertise in credit analysis benefits investors not only in our active bond funds, but also in our index fixed income funds, most of which use a sampling replication approach.
1 The Bloomberg Barclays Global Aggregate Credit comprised 16,504 bonds from 68 countries as at 1 October 2020.
2 Another difference is the importance of the banking system to corporate financing in Europe while in the US, corporate financing relies mostly on financial markets. According to New Financial research, 74% of corporate financing is via the bond market in USD, vs. only 23% in EUR and 46% in GBP.
3 20% of EUR-denominated debt (corporates only) in the Bloomberg Barclays Global Aggregate Credit total return index is from issuers domiciled in the US as of 1 October 2020.
4 Source: OECD, Corporate-Bond-Market-Trends-Emerging-Risks-Monetary-Policy as of FY18. The foreign ownership share of the outstanding amount of corporate bonds issued by corporate residents of the UK, the US, the euro area was respectively 56%, 28% and 18%.
5 Source: European Insurance and Occupational Pensions Authority (EIOPA). At the end of 2019, European insurers had €11.4tn in assets under management, 31.7% of which was held in corporate bonds and 31.5% in government bonds. Pension Funds in the European Economic Area had €2.4tn of assets (excluding the UK) as at the end of 2019, with 28% held in government bonds and 22% in other bonds.
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