Are you Buying Fair Assets at Wonderful Prices or Wonderful Assets at a Fair Price? A fixed income perspective.

The world of investing would be a wonderful place if we could do the same thing year in and year out and get great results every time. Unfortunately, opportunities move over time.  This may be most evident in credit investments that delivered wonderful results the past 2 years but now face historically low interest rates and spreads on corporate bonds. Despite the attractiveness of a 100% equity portfolio long term, not all clients can stomach the short-term volatility, and neither can their Investment Policy Statements (IPS).  We reviewed the $13T U.S. asset backed securities (ABS) market from a yield, issuance, and risk perspective vs corporate credit in deciding why ABS is a solution to fixed income woes and should be a bigger portion of client portfolios. 

Most investors look to fixed income and credit for yield, which is in short supply. The option adjusted spread on corporate A credit rated bonds was 67bps at the end of June 2021 . You can certainly apply 4X, 6X or more leverage to generate a decent return on 67 bps but as we saw in March 2020, credit can experience equity like declines when that much leverage is applied.  Today, for the same credit quality, you can apply no leverage and double your spread to 130bps by investing in “A” rated commercial mortgage-backed securities (CMBS). For BBB CMBS credit the yield spread is 230bps. Yield can also be enhanced by capital gains. While this is available in corporate as well as ABS securities there are currently more opportunities in ABS.        

There must be a risk trade-off for receiving double the spread on CMBS vs. corporate credit? CMBS are secured by hard assets (real estate) whereas corporate credit is unsecured, which would generally be viewed as a disadvantage for corporate credit.  That could be overlooked if a corporation’s “promise to pay” probability was improving, but the opposite is happening. The percentage of IG credit that is within the lowest rated category (BBB), has balloon to over 50% of the IG universe as of the end of 2020. The majority of new debt issuance in the last year is non-IG (including Sovereign issuance) and Moody’s forecasts that default rates on BB credit will rise and stay elevated around the high-end range of the last 20 years. Familiar names like Ford, Kraft-Heinz and Occidental Petroleum lead the volume of downgrades. In contrast, real estate values have largely been buoyant providing increased collateral (security) for CMBS/RMBS holders. There are areas of elevated risk within commercial real estate such as retail, but hard assets historically perform well in an inflationary environment.

Corporation are accumulating debt at a record pace. Total corporate debt in the U.S. was $5.5T at the end of 2008 and has since increased to $10.5T at the end of 2020. ABS in contrast grew from $11.2T to $12.7T over the same time. That equates to a 91% and 13% increase for corporate debt and ABS respectively. In 2021, despite record amounts of new corporate debt issuance the majority has been used to retire existing debt, meaning investors are getting less return for the same level of risk.  Massive government monetary stimulus that lowered yields on Sovereign debt has spilled over into the corporate market.  For large corporations that can access intermediated debt markets, the cost of debt has never been lower.  Quality borrows, that cannot access these markets are paying substantially more for credit, meaning the cost of liquidity has never been greater and opportunities are available for skilled managers to generate substantially higher returns through origination and other active strategies.  

While investing in familiar names, especially in a difficult environment for fixed income may feel safe, the risks for corporate credit investors have grown substantially. The benefits of ABS with higher yields, secured credit and lower overall debt levels should be cause for reflection when considering doing something less familiar. Delivering differentiated results, from looking more broadly in challenging markets is not only good for portfolio results, it can add to your clients’ confidence in you.