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Rating Events: One Theme to Follow in Global Credit Markets in 2020

Alongside pockets of weakness in credit markets come pockets of opportunity for active managers who focus on rigorous bottom-up research and careful credit selection.

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).

A figure features two graphs showing how ratings upgrades may create alpha opportunities. The first graph shows the option-adjusted impact of rising stars, where the spreads of high-yield bonds go negative before an upgrade to investment grade, at which time their spreads return to zero, then continue to about negative 70 basis points 10 months afterwards. The other graph shows cumulative excess returns of fallen angels, which bottom at around negative 10% at the time of the downgrade, but then rise steadily and return to the positive returns about six quarters afterwards

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.”

READ HERE

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.

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Sonali Pier

Portfolio Manager, Multi-Sector Credit

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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. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.

The option adjusted spread (OAS) measures the spread over a variety of possible interest rate paths. A security's OAS is the average earned over Treasury returns, taking multiple future interest rate scenarios into account.

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