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Financial Industry Insights from Advisors Asset Management

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Time to Add Investment Grade Credit?


In our previous Credit Insights pieces, we argued that we believe investment grade (IG) credit currently offers a potential sweet spot of offense and defense.

Now we make the case that investors are potentially underexposed to IG, and now may be an opportunistic time to consider adding exposure.

Are investors structurally underexposed to IG?

The most popular fixed income benchmark is ‘the Agg1' (formerly known as the Bloomberg Barclays Aggregate Bond Index) with over $1 trillion of active Core and Core Plus funds managed against it.

At first glance, the index can’t possibly be underexposed to IG, as it now has a higher weighting to IG corporates than ever.

However, painting a different picture, the Agg’s spread level relative to IG corporate credit is historically low, at just 44% of IG credit.

IG spreads look attractive vs the Agg's other spread components

From a market cap perspective, IG corporates have gone from providing 32% of the Agg’s total spread in 1990 to 63% today – almost doubling (Figure 1).

Figure 1: The share of credit spreads on the agg index has risen

 The share of credit spreads on the agg index has risen

Source: Bloomberg, Barclays, August 2020 (calculated by averages corporate IG OAS multiplied by IG market cap, divided by Agg OAS multiplied by Agg market cap)

In our view, this means the availability of IG spread has risen relative to other spread assets in the Agg (such as agency credit and emerging market debt).

This indicates to us that this could be an opportune time to consider tilting income/spread-seeking parts of Core and Core Plus allocations toward IG and less toward the Agg’s other spread sources.

A potential peak in corporate leverage could provide compelling timing for adding IG corporate exposure

Near term, corporate leverage may be peaking, offering a potential tailwind into year end.

Issuer debt metrics took a turn for the worse on both ends of the leverage equation this year (Figure 2). However, we believe much of the recent spike may reverse, partly for technical reasons.

Figure 2: Corporate leverage has risen to record levels but may have peaked

 Corporate leverage has risen to record levels but may have peaked

Source: Bloomberg, September 2020

First – on the debt side – gross issuance for 2020 at the end of August alone was already approaching an annual record at over $1.3tn (Figure 3).

Figure 3: Corporate issuance is already close to a record with nearly half the year still to go

Corporate issuance is already close to a record with nearly half the year still to go

Source: Deutsche Bank, August 2020

However, issuance is already slowing. Much of it was done to term out maturities and raise liquidity, and we believe this activity is largely complete. We therefore expect a tailwind from lower supply on IG credit.

Figure 4: U.S. corporate issuance is slowing down

U.S. corporate issuance is slowing down 

Source: JP Morgan, July 2020

Secondly – on the asset side of the equation – in Q2 2020 alone, earnings on the S&P 500 fell by 33.8% year-on-year, according to Bloomberg data (a quarter in which annualized GDP also fell by over 30%). Naturally, this has also pushed corporate leverage ratios up.

However, the real economy has since begun to recover, and management teams generally indicated improved outlooks during the earnings season. We expect earnings declines to moderate over the balance of this year. We also expect earnings growth of ~25% in 2021, which could potentially return corporate profitability to within 5% of its pre-COVID (and all-time) high.

This could indicate stability in leverage ratios, absent further major lockdowns and severe disruption from COVID-19.

Is it a good time to add IG exposure?

In the current environment, we continue to believe in IG with a security selection focus can offer a compelling combination of offense and defense.

CRN: 2020-1006-8613 R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management.

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 commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

Opinions expressed herein are as of September 21, 2020 and subject to change without notice. Information herein may contain, include or is based upon forward-looking statements within the meaning of the federal securities laws, specifically Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include all statements, other than statements of historical fact, that address future activities, events or developments, including without limitation, business or investment strategy or measures to implement strategy, competitive strengths, goals expansion and growth of our business, plans, prospects and references to future or success. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Words such as ‘anticipate,’ ‘estimate,’ ‘expect,’ ‘project,’ ‘intend,’ ‘plan,’ ‘believe,’ and other similar words are intended to identify these forward-looking statements. Forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many such factors will be important in determining our actual future results or outcomes. Consequently, no forward-looking statement can be guaranteed. Our actual results or outcomes may vary materially. Given these uncertainties, you should not place undue reliance on these forward-looking statements.


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