Economic and Market Commentary

Time to Give Credit Its Due?

Now may be a good time to consider high-quality segments of the credit sector. CIO U.S. Core Strategies Scott Mather explains the credits we favor – including agency mortgages and structured credit.

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Olivia Albrecht, Senior Vice President, Executive Office: So what are we thinking in terms of our exposure to corporate credit, and where are we finding opportunities today?

Scott Mather, CIO U.S. Core Strategies: Even though we don't think a true turn on the default cycle is imminent—that would be caused by a recession, which we also don't think is really imminent—there's reason for some caution in the corporate market. And you cited some of the reasons there. One, if you take that spread history and you adjust for the leverage—

Chart: A bar graph compares the growth in the BBB market: 2008 versus 2018. In 2008,U.S. BBB credit made up 32% of a $2.3 trillion market; in 2018 U.S. BBB credit made up 47% of a $6.1 trillion market.

where we are in the cycle you also adjust for the structural changes in the marketplace—which are it's a lower quality marketplace than it used to be, as is evidenced by the amount of triple Bs and the growth there—and then you further adjust by the change in liquidity—the amount of market making capacity that's there relative to the size of the market.

When you try to do some adjustments for all that, you find out, well, we're really on the tighter side with respect to spreads.

Chart: The double line graph compares spread over swaps for investment grade (Bloomberg Barclays Investment Grade) and high yield (Bloomberg Barclays U.S. High Yield) bonds from 1998 to 2018 annually relative to the investment grade and high yield averages. High yield moves along peaks and troughs throughout the period, peaking dramatically after 2008. Investment grade has a steadier progression, peaking slightly after 2008.

And so one shouldn’t be betting on further spread compression. We've had a sharp rebound this year so far correcting for what happened in November and December of last year. It’s the sort of environment we think where people should focus then on reducing their exposure, reducing their duration in corporate credit, focusing on shorter maturities and going up in quality.

Olivia Albrecht: Could you explain why we favor this segment and what we're doing in portfolios today to take advantage of our views on structured credit?

Scott Mather: The point we would make here in the case of residential mortgages is that unlike corporate credit through the cycle there's been a deleveraging event.

Chart: The line graph looks at the increase and decline of 60+ day delinquent mortgage borrowers from 2008 to 2019. From 2008 to 2009 the rise is steep, from 2010 to 2019 the decline is more gradual.

So not only as housing prices have gone up, the borrower credit quality has gone up,

Chart: The line graph looks at the decrease and increase of current FICO from 2008 to 2019. The line starts high, declines and then rises in a u-shape curve.

and the structures themselves that these loans are packaged in have delivered. So it's very different. While the corporate market credit quality has been generally declining year by year, it's actually been increasing with respect to some of these legacy non-agency mortgages.

And people should remember that yes, there'll be some weakness in the next recession that will pressure some of these trends the other direction. But in general it should be a much more resilient sector, nothing like it was in '07-'08 when we had a different host of problems. That's one of the reasons why we expect this sector—the credit related mortgage sectors—to significantly outperform traditional corporate credit in the next true downturn that we get. So yes, favor non-agency mortgages.

We also favor agency mortgages. Obviously, one of the most liquid spread products aside from governments that there is out there. And when you look at those spreads, we're on the cheaper side of long-time fair value. And it's hard to say that with many other spread sectors out there today. So once again, very liquid, high quality sector that gives you a spread pickup relative to government's.

Away from mortgages, it's also the case that we favor a lot of asset backed securities, a lot of structured credit, once again, because of the resilience that those particular securities will have. As long as you stay higher up the credit quality spectrum, in the next true turn of the default cycle they should significantly outperform their corporate counterparts.

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All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Structured products such as Collateralized Debt Obligations (CDOs) are complex instruments, typically involving a high degree of risk and intended for qualified investors only. Use of these instruments may involve derivative instruments that could lose more than the principal amount invested. The market value may also be affected by changes in economic, financial, and political environment (including, but not limited to spot and forward interest and exchange rates), maturity, market, and the credit quality of any issuer.

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