Outside-IN

The end of the Goldilocks credit markets?

Going forward, the fixed-income environment may favor more sophisticated active approaches, such as flexible 'best ideas' strategies

May 21, 2018 @ 10:24 am

By Gautam Khanna

"Goldilocks" was the byword for credit markets in 2017. The first synchronized global economic expansion since the financial crisis underpinned a strong rally in credit spreads. Economic growth and inflation ran "just right" to support asset prices. It also resulted in the lowest average levels of volatility in equity market history (as measured by the Vix Index).

The first signs that Goldilocks is threatened came in February 2018, when concerns about rising inflation and rates contributed to the largest ever one-day spike in the Vix. The Goldilocks narrative has also come under fire given the recent trade-related talk with China.

Nonetheless, credit spreads still trade at some of their richest post-crisis valuations, being justified by an economic backdrop that remains strong. This should translate into robust corporate earnings growth. Indeed, a forecast for continued low default rates in 2018 is justified. Given the expectation of higher interest rates, a shorter duration exposure is appropriate and economic fundamentals don't yet justify being short credit risk. But current tight valuations, a potentially normalizing volatility backdrop, the threat of inflation and the reversal of monetary stimulus warrant an "index-agnostic" approach to portfolio construction. Prudent security selection is mandatory.

One thing is clear — this is not the type of straightforward environment in which passive investors or active index-constrained "benchmark huggers" tend to feel most comfortable. This environment might be better suited to active and dynamic "best ideas" approaches, where sector and security selection can exploit the most value.

(More: What advisers should tell clients about the inverted yield curve)

End of easy credit returns?

There are a number of reasons to believe that the "Goldilocks zone" is unsustainable.

Global growth is increasing toward its potential, likely the highest point at which current level of inflation can be sustained. U.S. unemployment at 4.1% is one of the lowest on record. According to the Phillips Curve, unemployment and inflation have an inverse relationship as tight labor markets force companies to compete for existing workers through higher wages. Inflation pressures are therefore likely to build.

The Federal Reserve is normalizing monetary policy and reducing its balance sheet while central bank support elsewhere is peaking.

Where now for corporate bonds?

Credit markets should not react too unfavorably to inflationary impulses or rising yields if they are orderly and contained, but sharp rises would be a concern.

This adds to the challenges facing credit investors. Credit spreads are at some of their tightest since the global financial crisis, potentially exposing investors to market corrections.

'Best ideas' approach

Not all segments of the global market are in sync and active management is better positioned to capture the value from that nuanced reality. Strategies that can look across the full spectrum of US and global investment grade credit markets, regardless of a benchmark, are best positioned to extract better returns. Freedom to take advantage of relative value opportunities across diffferent issuers and up and down the capital structure, across sectors and/or global credit regions is also important. This index-agnostic approach can also add additional diversification from areas such as high yield, secured loans, emerging market debt, asset-backed securities or more esoteric investments. Secured finance for instance, offers a complexity premium above comparably rated corporate credit, which is attractive for sophisticated investors. Managers can also hedge interest-rate risk or adopt a short-duration exposure.

Generating 'best ideas'

The difficulty of investing in credit strategies on a "best ideas" basis is that it requires considerable resources and expertise. Not having a benchmark to hide behind requires diligent, bottom-up credit expertise that seeks to identify future rising stars as opposed to just avoiding future fallen angels.

Those with access to the required skills are well-placed to overcome the flaws of traditional index-based approaches in the current environment.

(More: Investing in bond funds when interest rates rise)

Gautam Khanna is a senior portfolio manager at Insight Investment, a BNY Mellon subsidiary.

0
Comments

What do you think?

View comments

Recommended for you

Upcoming Event

Nov 13

Conference

Best Practices Workshop

For the sixth year, InvestmentNews will host the Best Practices Workshop & Awards, bringing together the industry’s top-performing and most influential firms in one room for a full-day. This exclusive workshop and awards program for the... Learn more

Featured video

Events

InvestmentNews celebrates diversity & inclusion in the financial advice business

Highlights of the Excellence in D&I Awards, showcasing the achievements of 26 individuals and firms that are moving the needle when it comes to diversity and inclusion.

Latest news & opinion

Divided we stand: How financial advisers view President Trump

InvestmentNews poll finds 49.2% approve of his performance, while 46.7% disapprove. How has that changed over the course of his presidency?

10 states with the most college student debt

Residents of these states have the most student debt when you consider their job opportunities.

Ex-Wells Fargo brokers sue for damages, claiming they lost business in wake of scandals

In a Finra arbitration complaint, two brokers allege that Wells Fargo's problems damaged their business.

Invesco to buy OppenheimerFunds

Deal brings Invesco another $246 billion in assets, as well as high-fee actively managed funds.

Dawn Bennett found guilty of $20 million Ponzi scheme

Jury took less than five hours to convict the former financial adviser and radio host.

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print