INSIGHTS

On May 18, 2015

AAM Viewpoints - Taking Comfort in Credit Risk

“A lot of people approach risk as if it's the enemy when it's really fortune's accomplice.”

- Sting, English actor & rock singer (1951 - )

Interest rate risk in the current market looks to be one of the biggest risks to fixed income investors moving forward. Stated another way, the compensation investors receive for taking on interest rate risk stands at historical lows. The modest 22 bps (basis points) movement in the 10-year Treasury rate from 2.03% on 04/30/2015 to 2.29% on 05/13/2015 represented a holding period return of -2.079% and all but wiped out the annual coupon of 2.125% on the current issued 10-year Treasury bond. Since 2000 the effective duration on the U.S. Investment Grade corporate market has risen over 1.5 years while coupon rates have fallen over 2.70%. The Barclay’s Aggregate also reflects a meaningful increase in interest rate risk with the yield per unit of duration sitting at all-time lows.

Credit risk, on the other hand, looks to provide a much better risk-to-reward tradeoff in the current market. The compensation an investor receives for taking on credit risk is measured by “credit spreads.” Credit spreads are the difference in yield between U.S. Treasuries and corporate bonds of the same maturity. These spreads are the “credit premium” investors demand for taking on the risk of default inherent with an investment in corporate debt. Credit spreads are sensitive to the health of an economy and the credit conditions that prevail at a given time. As conditions improve, spreads narrow driving price appreciation and as conditions worsen spreads widen leading to price depreciation. Because the Federal Reserve typically begins to raise rates during periods when credit conditions are healthy and/or improving, taking on credit risk with an expectation of rising rates could provide some cushion against interest rate risk. Lower rated bonds are still susceptible to interest rate movements but potential credit spread tightening could help to improve total return performance.

Studies by The Federal Reserve have shown both a positive and negative relationship between U.S. Treasury rates and corporate credit spreads with the direction of the relationship dependent upon the time horizon under consideration. In the short run, there is a negative relationship with credit spreads narrowing as rates rise. Over longer timeframes there is a positive relationship with credit spreads widening with higher rates.

From an economic standpoint this would seem to make sense, especially when considering market cycles. The Federal Reserve begins to tighten when and where they are concerned about inflation and the economy “overheating.” This would normally occur amidst generally healthy credit conditions with improving corporate balance sheets, strong equity markets and lower than average corporate default rates. Over the short run, one would expect credit spreads to narrow during the infancy of a tightening cycle as the overall environment is still expansionary with healthy credit metrics. Short run analysis, in this regard, would generally only reflect peaks in the business cycle. As the timeframe is pushed out and one begins to consider both peaks and troughs in economic cycles, credit spreads take on a positive relationship with rising rates because credit spreads widen as economies weaken.

Source: Advisors Asset Management, Inc.

This relationship is important because it provides investors with some insight into expectations for credit-sensitive fixed income as rates rise and also provides a framework for the informed acceptance of credit risk to theoretically cushion the effects of rising rates through credit spreads narrowing. While credit is not immune from interest rate risk, one would expect that the potential does exist for credit to outperform on a total return basis, relative to more rate-sensitive investments, during periods of healthy credit conditions. This has certainly been the case since the credit crisis.

Source: St. Louis Fed

When comparing returns on more credit-sensitive bonds to their higher grade counterparts, we see significant outperformance post credit crisis. BBB-rated bonds, the lowest rung of investment grade with more risk of default than higher grade obligations, have outperformed single-A and better sectors of the market by a significant margin post credit crisis. This reflects the spread tightening that has occurred in the credit markets over the last seven years as credit conditions have improved. BBB-rated corporates have outperformed their single-A counterparts by over 300 bps (10.525% vs. 7.397%) on an annualized basis for the time period from 12/31/2008 to 05/13/2015.

There are reasons to expect that this trend of credit-sensitive outperformance versus more rate-sensitive investments will continue. Credit conditions are still very favorable with expectations of continued strength in the United States, which should support the health of corporate balance sheets. Corporate default rates are lower than historical norms and likely to remain low moving forward, in our opinion. Markets are likely to maintain a preference for credit risk over interest rate risk and the lower absolute level of rates will likely continue to push yield hungry investors down the ratings scale in search for additional return.

Spread measures also point to what could be attractive valuations in more credit-sensitive investments. In the BBB-rated spectrum, spreads to comparable treasuries, yield premiums and spreads to higher rated securities are all still wider than pre-credit crisis levels and wider than historical spread levels over the last 15 years.This stands in contrast to higher grade A or better rated corporates which are at or near historical averages. In some cases as you step up the ratings scale are narrower on a spread to treasury basis than historical averages over the last 15 years.

Source: St. Louis Fed

In conclusion, informed exposure to credit risk has the potential to provide better total return performance for investors than the acceptance of interest rate risk in the current environment. Credit conditions look to remain favorable and could provide further price appreciation through credit spread tightening. Investors will likely continue to search for yield by stepping down the quality scale and spread measures continue to reflective attractive valuations in lower grade securities. Finally, exposure to credit risk has the potential to provide a total return benefit versus higher grade securities and offer a potential cushion in volatile rate environments. For these reasons we would favor credit risk in lieu of interest rate risk moving forward. As always, client situations take precedent, lower grade securities might not be appropriate for all investors and diversification is paramount.

CRN: 2015-0518-4760R 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com