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Financial Industry Insights from Advisors Asset Management

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Credit: The Asset Class to Watch for The Mid Cycle


As the U.S. recovery graduates from the 'early' to the 'mid' cycle, we expect growth to moderate from 'very high' to 'high.' As such, lower-rated credit may be the risk asset class to watch.

Equity market tailwinds are starting to moderate

The fastest economic recovery in history, driven by unprecedented technical market support from the Federal Reserve (Fed) and the Treasury, has been generally kind to the highest risk ‘growth’ assets.

As such, since the pandemic downturn of March and April 2020, equity markets have had an excellent run.

However, as we transition from the early cycle phase of the recovery to the mid cycle, we believe growth will likely remain solid, but lower than at the apex of the recovery. This may make for an increasingly positive relative value environment for higher yielding credit.

The traditional 'mid cycle slowdown' explained

History shows that equity markets tend to perform strongly following a downturn as the economy bounces back. However, as the economy’s low-hanging fruit gets plucked (e.g. the easy job gains from the post-pandemic reopening), the pace of growth typically becomes harder to maintain.

The transition to mid cycle tends to occur when monetary stimulus is scaled back or withdrawn, as reflected by the Fed tapering its asset purchases.

In the past, equity markets have sometimes experienced pricing corrections and higher volatility as markets recalibrated to a new growth trajectory.

Higher-yielding credit may therefore be the asset class to watch

High yield and lower-rated credit tend to look attractive mid cycle

When economic growth moderated from high levels, higher yielding fixed income credit markets has tended to perform best on an excess return basis (Figure 1).

Figure 1: Moderating growth has often been the sweet spot for lower-rated credit

Moderating growth has often been the sweet spot for lower-rated credit
Source: Bloomberg, Insight calculations, using excess return and gross domestic product (GDP) data from 1990 to September 2021. Past performance does not guarantee future results.

Moderating growth has typically worked well for credit investors because it implies continued revenue and earnings growth, which allows for companies to de-lever organically and typically leads to improving credit metrics. Historically, the highest growth environments have been less compelling for high yield on an excess return basis, as they have tended to be early cycle periods in which rates fell, which propelled government bonds and equities more than high-yield credit.

Moderating growth has tended to be less positive for equities, given the downward adjustment in growth expectations from very high to merely high levels.

Three reasons we believe lower-rated credit may outperform high-grade credit in a moderating growth environment

In our view, BBB and BB-rated credits offer more compelling value than high grade credit (single A or above) in a moderating growth environment.

1) Interest rate risk is less of an issue for BBB and BB-rated securities

High grade credit returns are often dominated by interest rate risks, and during the midcycle, monetary accommodation is typically scaled back or reversed.

The Fed is now tapering its asset purchases and is potentially set to commence a lift off in interest rates shortly after tapering is complete. It is also important to recognize that corporations have taken advantage of low rates to issue longer-dated debt, increasing the interest rate sensitivity of the investment grade corporate index relative to its history. High yield bonds, however, tend to be shorter dated, with credit spreads rather than duration having greater influence on total returns.

2) Lower-rated companies are incentivized to de-leverage

As growth moderates, and organic growth becomes less easy to deliver to shareholders, equity investors often pressure corporations to inorganically improve equity returns through share buybacks or mergers & acquisitions (M&A).

However, these activities increase corporate leverage. Therefore, the companies most prone to this behavior tend to be single-A rated companies or above, as they have the greatest room to increase leverage. Even if it inflicts a credit ratings downgrade, the spread penalty for downgrades from single A to BBB has been relatively low (Figure 2).

Figure 2: A-rated companies face little spread penalty for a downgrade to BBB

A-rated companies face little spread penalty for a downgrade to BBB
Source: Bloomberg, BofA Merrill Lynch, April 2021. Past performance does not guarantee future results.

BBB and BB-rated companies, by contrast, have little incentive to pursue activity that could result in credit ratings downgrades, as the penalty becomes more severe the further down the ratings spectrum companies venture.

In fact, many BBB and BB-rated companies are former A-rated corporates that were downgraded due to previous M&A deals. They are now on a path toward de-leveraging. BBB companies are often incentivized to avoid a downgrade into high-yield territory and BB are incentivized to chase an upgrade to investment grade.

We call this phenomenon, in which corporate ratings tend to gravitate to BBB, the ratings cycle. (Figure 3)

Figure 3: The ratings cycle typically favors lower-rated credits during the midcycle

The ratings cycle typically favors lower-rated credits during the midcycle

Source: For illustrative purposes only.

3) The high yield compression trade may have more room to run

High-yield credit spreads have generally lagged the recovery in investment grade markets since the start of the pandemic, leaving a sizable premium between the two.

As such, we believe potential rising demand for high yield means there could be more room for high-yield spreads to compress (Figure 4).

Figure 4: There could be more for investors to squeeze from the high yield compression trade

There could be more for investors to squeeze from the high yield compression trade

Source: Bloomberg, Insight, Federal Reserve as of September 30, 2021.

Playing high-yield credit opportunities in a bond-picker's market

Investing in lower rated credit always needs to be done with care, with the aim of avoiding the credits on their way to distress or default. Sector and security selection is therefore important. In our view, there are three broad themes investors may wish to consider.

1) Pivot to sectors set to benefit from productivity growth

We also believe that U.S. growth is likely to become increasingly driven by corporate Research & Development (R&D) and, as a result, productivity growth. In the U.S., business spending on equipment, structures and software reached 6.7% in the first half of 2021 — the strongest pace since 1984 (Bloomberg, October 2021). Part of this has been driven by the need for remote working due to the pandemic.

Almost all sectors have already been benefiting from productivity growth, with output largely rising despite fewer workers (Figure 5). However, the full fruits of this uptick in business investment could potentially improve productivity growth further.

Figure 5: Productivity growth has been improving across many sectors

Productivity growth has been improving across many sectors

Source: Bureau of Labor Statistics as of August 31, 2021, Bureau of Economic Analysis as of June 30, 2021

Beneficiaries may include industrials and other sectors leaning into the growing digital economy, as well as semiconductor suppliers that have been expanding production to meet rising demand for equipment. South Korea, for example, plans to spend roughly $450 billion, led by its electronics giants, to build the world’s biggest chipmaking base over the next decade.

2) Global credit outside the U.S. may benefit from a catch up in GDP

The U.S. had a head-start on the economic recovery due to the relative size of its fiscal response and rapid initial vaccine rollout. Much of the rest of the world is now catching up. As the U.S. moderates into the midcycle, its peers are just beginning their early cycle recoveries (Figure 6).

Figure 6: The U.S. had a head start on many countries in its recovery 
The U.S. had a head start on many countries in its recovery

Source: Bloomberg, September 2021.

As such, investors may wish to cast their net beyond U.S. dollar credit, and consider opportunities across the globe, both in developed markets and emerging market debt.

Closer to home, the performance of global markets could also potentially benefit U.S. exporters, as we expect the worldwide recovery to ease the U.S. trade deficit (Figure 7).

 
Figure 7: U.S. exports may rebound as the rest of world sees a delayed recovery

U.S. exports may rebound as the rest of world sees a delayed recovery

Source: Bloomberg, September 2021

3) Fallen angels could be the key to capturing rising stars

Targeting the fallen angels market (bonds whose rating declined from investment grade to high yield) may offer a compelling proposition for investors as fallen angels have historically delivered equity-like returns with bond-like volatility (Figure 8).

Figure 8: Fallen angels have historically delivered equity-like returns for bond-like volatility

Fallen angels have historically delivered equity-like returns for bond-like volatility

Source: Bloomberg, December 2004 to June 2021. Past performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations. It is not possible to invest in an index.

Historically, rising stars (high-yield issuers that are upgraded to investment grade) have been almost twice as likely to come from the fallen angel market than the broader high yield market (Bloomberg, June 2021). We see the potential for a solid increase in rising stars next year given the strong economic backdrop

Now is the time for a midcycle playbook

With the easy part of the U.S. recovery out of the way, we believe more investors should consider this a potential sweet spot for BBB, BB, fallen angels and global credit (including both developed and emerging market debt).

In our view, higher-yielding credit sectors could be the risk asset class to watch for the midcycle phase of the current economic expansion.

CRN: 2021-1214-9653 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 http://www.aamlive.com/.

Please note: any forecasts or opinions expressed herein are Insight Investment's own as of December 9, 2021 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. Actual results or outcomes may vary materially. Given these uncertainties, you should not place undue reliance on these forward-looking statements.

AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. Lower-rated securities present a greater risk of loss to principal and interest than higher-rated securities. 


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