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Investing in credit: Building robust portfolios for the long term

  • Institutional investors have long been investing in credit. The current credit cycle fuelled by the inflation of Central Banks’ balance sheets has however provided a relatively easy ride to credit investors, with little incentive to differentiate between issuers.
  • With structural changes, such as increased transaction costs and the credit cycle nearing an end, some investors have started to question whether the asset class is offering sufficient value after transaction costs and credit events are accounted for. Rather than reducing their exposure to the asset class altogether, institutional investors concerned about these developments may be better off paying more attention to issuer and issuance selection, and avoiding some types of credit.
  • In this paper, we highlight some of the structural changes the credit market has undergone recently and suggest ways in which investments based on fundamental analysis in an unconstrained framework could help generate sustainable, long-term return streams while managing the heightened risk in credit.

Structural changes within the credit markets today. Traditionally, fixed income markets have been structured as over-the-counter (OTC) markets with banks acting as market makers or dealers. As dealers, banks have been the ones providing liquidity by warehousing corporate bond inventory when buyers and sellers are not immediately available to settle a transaction. This has ensured the stable functioning of corporate bond markets.

After the Global Financial Crisis (GFC) however, regulatory reforms such as Basel III, the Dodd-Frank Act of 2010 and the Volcker Rules on proprietary trading, have resulted in greater capital and liquidity requirements for banks. As such banks are unable to maintain large inventories of corporate bonds (as illustrated using the US market in Figure 1) and market making in this sphere is no longer as lucrative for them. A majority of the corporate bond inventory therefore has shifted from bank balance sheets to investors. This means banks are unable to be efficient market makers – leading to lower liquidity in the system as a whole, which in turn increases the transaction costs of trading.

As a relative measure too, transaction costs have become a larger proportion of the yields available as illustrated using the Sterling market in Figure 2. Hence minimising transaction costs has become a key consideration in managing a credit portfolio.

In addition to the regulatory reforms discussed above all major central banks (including the Fed, ECB, BoE, BoJ) have employed quantitative easing (QE) to help stabilise their economies in the wake of the GFC. While QE was critical in breaking the downward momentum of the crisis, it is now becoming clear that this benign credit environment is not going to be sustainable as the global economy approaches the peak of the long-term debt cycle.

Source: AXA IM and Bloomberg LP as at 31/05/2018. For illustrative purposes only.

Adjusted for the size of the bond market as measured by the BofA Merrill Lynch US Corporate Index (C0A0). US Corporate Bond inventory is measured by the sum of Primary Dealer Positions Net Outright Total Corp Securities (PDPPCRP2), Primary Dealer Positions Net Outright Non-Agency

Residential MBS (PDPPGCMB), Primary Dealer Positions Net Outright Other asset-backed securities (PDPPOABS) and Primary Dealer Positions Net Outright Other CMBS (PDPPOCMB).

Source: UBS Delta, iBoxx Sterling Non-Gilts Index, 01/01/2006 - 31/05/2018. For illustrative purposes only.

 

Just as transaction costs are a larger proportion of available yields in today’s environment, credit spread makes up a significant part of the total return an investor can hope to receive as illustrated using the US market in Figure 3 (11% at the end of 2000 versus 45% in May 2018). With a reduced buffer to compensate for potential defaults,the quality of credit analysis and risk assessment has become even more important for investors, particularly in the anticipated less-benign credit environment.

Source: AXA IM and Bloomberg LP as at 31/05/2018. Data shown for the BofA Merrill Lynch US Corporate Index (C0A0). For illustrative purposes only.