Active approach to navigating the credit market

Ivy Securian Core Bond Fund
02.12.20

Fixed income market overview

While the stage is set for stronger growth in Corporate America, the turn hasn’t happened yet. The U. S. Federal Reserve’s (Fed) series of interest rate cuts in 2019 was a reaction to slowing economic growth both in the U.S. and China, reduced business spending, plateauing corporate earnings growth and anticipation of instability driven by the trade war.

Manufacturing continues to struggle, with weakness in energy and trade putting a damper on investment. In addition, a historically low unemployment rate is making it challenging for many companies to add the workers they need to scale up production.

In our view, fixed income investors are more likely to detect recessions before other market followers. One warning sign fixed income investors saw in 2019 was a series of yield curve inversions, locking in lower yields on long-term Treasury notes while demanding higher yields from short-term Treasury bills. Historically, inverted yield curves have predated recessions.

The decade-long bull market could make a strong case for passive investing in equities. Now, this same sentiment may convince fixed income investors to do the same. However, we would argue equating passively managed equity investing with passive fixed income investing is like comparing apples to oranges.

The one-size-fits-all attraction of passive fixed income strategies can expose investors to greater risks than those associated with equity index funds.

The average option-adjusted spread (OAS) stands at approximately 75% of the 10-year average for Bloomberg Barclays U.S. Aggregate Corporate Index, the Fund’s benchmark, despite the fact that the credit quality of the index deteriorated dramatically over that time. The BBB-rated weight within the index has risen by nearly 15% over that time to over half of the investment grade universe.

The current credit cycle is much closer to its end than its beginning. Fortunately, credit markets are resilient, dynamic and often provide opportunity to investors who prefer to not run with the herd. The key to being prepared for the next slowdown is to rely on the fundamentals of credit investing, recognizing that credit rating or benchmark weight has limited correlation to actual risk in difficult markets.

The case for a more nimble approach

We believe there are fundamental flaws with major credit indices because the basic premise upon which these credit indices are constructed is inadequate. The concept that a higher debt load results in a larger index weighting is offensive to even the most novice credit investor. Unlike the major equity indices, which are largely a reflection of the market’s valuation of expected company earnings capacity, fixed income benchmarks reward aggregate debt. Given the massive increase in debt issuance over the past 10 years, this should be very concerning to credit market participants. In fact, the Bloomberg Barclays U.S. Aggregate Bond Index raised the minimum debt criteria in 2017 from $250 million to $300 million as increased incentive to profligate borrowing.

Chart Showing OPTION-ADJUSTED SPREAD (OAS) % OF 10-YEAR AVG AND BBB% OF IG CORPORATES
Chart Showing OPTION-ADJUSTED SPREAD (OAS) % OF 10-YEAR AVG AND BBB% OF IG CORPORATES

Source: Bloomberg Barclays, Securian Asset Management, Inc. Illustrates the degradation in credit quality despite tightening credit spreads, 2009-2019. Past performance is no guarantee of future results.

Furthermore, the idea that fixed income indices are “passive” is largely a fairytale. Certainly, the financial capacity of any company to service its nominal debt load must be considered in determining its credit worthiness. Rating agencies make active decisions that impact which issuers will be included within a particular index and which ones will be left out. The credit rating decision is very much arbitrary and very much active. For example, giving one company years to reduce debt after a large acquisition while penalizing another immediately. They may see one industry as more defensive than another or give credit to companies that have larger scale while penalizing those that are smaller. Given the performance of the rating agencies, particularly in times of turmoil, there should be little comfort in credit ratings.

The critical flaws of the benchmark framework have been exacerbated by increased dependence upon them since the last recession. Behemoth asset managers in fixed income markets have increased the risk to investors. Their sheer size, a limited market liquidity environment and the comparative ease of modeling larger benchmark securities has resulted in a crowding effect in large capital structures. The increased adoption of passive investment vehicles to gain quick exposure to fixed income markets has also increased the risk to investors.

This increasing credit risk reduces the overall credit quality of passive funds that track to the Bloomberg Barclays U.S. Aggregate Bond Index. Why? Because their mandates often restrict deviations from the index. This means they must take on the added debt of constituent companies, even if their underlying fundamentals are weakening.

Among active fixed income managers, smaller fixed income managers whose funds have a nimble level of assets relative to behemoth fund complexes can have certain advantages. They’re not pressured to hold hundreds or thousands of positions to keep the portfolio fully invested. Smaller fixed income managers are able to take advantage of offbenchmark credit opportunities by applying an active, fundamental approach to reviewing credit and not being tied to only holding securities that are held in the benchmark. Flexibility in portfolio construction allows for the ability to select bonds and structured securities that offer greater opportunities for yield and avoid companies that are potentially overly indebted.

Why this matters for long-term investors

It is easier for nimble fixed income managers to efficiently focus on the smaller end of the fixed income market for the potential of better risk-adjusted returns. Because they’re not bound by broad index constraints, the smaller managers can rely on their own proprietary research tools to manage credit risk and identify yield opportunities. They can identify yield premiums by using technical analysis to identify dislocation and mispricing opportunities within sectors or among individual securities. In addition, their mandates often allow them to take advantage of yield premiums offered by private placements and other alternative investments. And when recessions occur, their smaller portfolios often enable them to exit positions more efficiently and thoughtfully than larger firms that must quickly make hundreds of trading decisions to generate liquidity to accommodate outflows.

An example is in the structured market with Credit Risk Transfer (CRT) Bonds. CRTs were created in 2013 to transfer portions of risk from conventional residential mortgage loans backed by government-sponsored agencies, such as Fannie Mae and Federal Home Loan Mortgage Corporation (Freddie Mac), to private sector investors. These are unsecured general debt obligations, with principal and interest payments made on them monthly by the issuing government-sponsored agency. They have a floating rate of payment indexed to the 1-month LIBOR rate and a maturity of either 10 or 12.5 years.

In general, we use fundamental bottom-up research and seek to add value to the portfolio through security selection. We have been an investor in residential credit for many years. In selecting CRT bonds, we employ scenario analysis to stress the bonds under a range of economic environments by shifting several variables (i.e. prepayment speeds, defaults rates, and recoveries). In addition, these bonds provide the portfolio with consumer credit exposure, which is an important source of diversification away from corporate credit. We find the CRTs to be a fit within our portfolio because, on average, they tend to offer borrowers with excellent credit scores, geographically diverse home ownership locations and floating rate coupons, which benefit during periods of rising interest rates.

Summary

An uncertain fixed income market favors managers who can be nimble and selective and focus on finding yield premiums and higher credit quality outside the larger issuer universe. For example, right now, bonds from highly rated (A to A-) smaller issuers offer a yield premium ranging from 9 to 41 basis points higher than their larger counterparts. Some of this yield premium reflects the overall lack of market efficiency in the small end of the market. With mainstream investors favoring larger issuers, bonds from smaller companies are often undervalued, providing open-minded fixed income investors with opportunities to selectively exploit these opportunities.

When the economy is on a roll and markets are rising, investing in passive funds and active index-huggers may seem like the thing to do. However, when warning signs like weakening fundamentals and declining credit quality rear their ugly heads, prudent fixed income investors may be better off shifting some of their assets to smaller, more nimble fixed income asset managers who may be better prepared to weather the approaching storm.

Bloomberg Barclays
Index Credit Rating
# of Issuers
Option-Adjusted Spread (basis points)
   
All Issuers
Less than $5B
(Small Issuer)
$5 - $20B (Medium Issuer)
Greater than $20B (Large Issuer)
Small-Large Premium
A+ to A- 973 109 125 108 102 23
A+ 206 96 122 100 81 41
A 424 105 122 104 97 25
A- 343 122 129 119 120 9

Source: Bloomberg Barclays U.S. Aggregate Corporate Bond Index and Securian Asset Management, Inc.
Chart looks at the aggregate amount of debt outstanding by issuer and the OAS on each index-eligible issue. Past performance is no guarentee of future results.


Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through February 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpyment of interest or principal than higher-rated bonds. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

The Bloomberg Barclays U.S. Aggregate Bond Index is market capitalization weighted index, representing most U.S. traded investment grade bonds. It is not possible to invest directly in an index.