Credit markets have rallied significantly over the past few years, with spreads over Treasuries in the U.S., for example, dwindling to very tight levels alongside decreasing yields. At the same time, many investors have raised concerns over credit market volatility, liquidity, potential overvaluation, and vulnerability within certain sectors. Overall, we believe the trends in global markets call for a cautious approach to generic corporate credit beta.
A defensive approach is not synonymous with avoiding the credit sector in its entirety, however. Alongside these pockets of weakness come pockets of opportunity for active managers who focus on rigorous bottom-up research and careful credit selection. We tend to favor short-dated, default-remote “bend but don’t break” corporate exposures, and in the current stage of the credit cycle we are especially cautious in assessing what fits into this category.
A closer look at ratings migrations
Amid the overall tendency toward caution in corporate credit, one metric may come as a surprise: the ratio of credit rating upgrades versus downgrades of issuers and individual securities. If we were seeing pervasive downgrades across the market, we would tend to infer that companies and even the overall economy are struggling. However, we saw quite a different picture in the U.S. in 2019, when the outstanding debt of rising stars (defined as issuers upgraded to investment grade) dramatically outpaced that of fallen angels (issuers downgraded to high yield), with a ratio of $69 billion to $17 billion (source: Goldman Sachs as of December 2019). This trend is a continuation of a theme we have observed over the past few years as the economy has continued to grow, albeit at a more modest pace: As companies face a less challenging earnings environment, issuers have been able to maintain or improve their credit ratings, leading to more rising stars. Of note, it’s important not to rely solely on credit rating agencies’ assessments; thoughtful bottom-up analysis of individual issues, companies, and sectors is crucial.
This intriguing trend in credit markets gives rise to an opportunity to target attractive risk-adjusted returns. To successfully navigate ratings events requires a flexible and forward-looking approach, which can help investors to time positioning correctly and capitalize on rising star candidates while avoiding fallen angels. One way to take a forward-looking approach is to conduct careful credit research analysis to individually rate each issuer and tier of the capital structure independent of the rating agencies. This may enable portfolio managers to capture rating inefficiencies in the market. Real value in corporate credit may be extracted by identifying potential trends in ratings migrations in advance of the broader market, allowing investors to aim to be advantageously positioned at the right time.
Additionally, the diverse buyer bases and market size of high yield and investment grade credit (e.g., some investors avoid high yield due to investment restrictions or preferences) may drive a positive technical tailwind benefiting investors who have flexibility to hold both investment grade and high yield credit in their portfolios. As credit markets experience ratings migrations, well-prepared investors may be able to take advantage of this structural alpha opportunity. For example, one trend we have observed is that rising stars’ spreads tend to tighten up to a year in advance of the upgrade, whereas fallen angels’ prices tend to fall in advance and rebound thereafter (see chart).
Credit in context
While our baseline global macro outlook includes a moderate economic recovery in the course of 2020, we remain defensive on generic corporate credit given its risk/return characteristics. Indeed, we are monitoring risks in the more vulnerable segments of global credit markets that could hinder an economic recovery – though this is not our baseline view. The relative prevalence of rising stars in U.S. credit markets is one example of why an active, bottom-up approach can help investors target intriguing opportunities within the overall tight corporate credit market.
For further insights into high yield markets, please read “Spotlight on High Yield Credit Amid Declining Yields in Fixed Income Markets.”
Sonali Pier is a portfolio manager focusing on high yield and multi-sector credit strategies, and she is a regular contributor to the PIMCO Blog.