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Time for credit selection to shine

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This is a sponsored article from Wellington Management.

Author: Connor Fitzgerald, CFA, Fixed Income Portfolio Manager

Credit investing in an era of higher rate volatility

It is no surprise that markets are still in flux as we enter the second half of 2024. Several underlying forces are driving the new regime of higher inflation and cyclical volatility, among them the deteriorating fiscal position in the US, a financial system awash with excess savings and liquidity, and the impact of escalating geopolitical risk on supply chains.

Against this backdrop, it is difficult for central banks worldwide to set policy with conviction. At the same time, lags in monetary stimulus are becoming exacerbated, so the cycle of market swings and uncertainty continues.

For fixed income investors, we believe a crucial implication of this environment has been rising interest-rate volatility. In the US, volatility increased from 4.2% after the global financial crisis to 7.2% following the significant rebasing of US inflation in March 2022.1 Income-orientated strategies that hold large, static exposures to credit markets have felt the unsettling impact of this new era of higher US interest-rate volatility. (Figure 1).

“BLOOMBERG®” and the Bloomberg indices listed herein (the “Indices”) are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the Indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by the distributor hereof (the “Licensee”). Bloomberg is not affiliated with Licensee, and Bloomberg does not approve, endorse, review, or recommend the financial products named herein (the “Products”). Bloomberg does not guarantee the timeliness, accuracy, or completeness of any data or information relating to the Products. PAST INDEX OR THIRD-PARTY PERFORMANCE DOES NOT PREDICT FUTURE RETURNS. | Chart data: 30 September 2008 – 31 May 2024.

Faced with these market dynamics, it has become increasingly important — as I discussed recently in this publication — to mitigate the risk of volatile interest rates while seeking to capture the opportunities available from the fluctuating performance of the US credit sector relative to US Treasuries. In my view, rotating between US credit sectors and US Treasuries as valuations evolve is a potentially compelling way of navigating this environment.

Adapting to a brighter US economic outlook

There are a number of bright spots in the outlook for the US economy. Healthy consumer balance sheets and low sensitivity to interest rates, among various factors, make a consumer-led slowdown less likely. Therefore, I see limited scope for downside in investment grade credit spreads.

More specifically, solid fundamentals reflect a prudent approach by many US corporates in recent years. This began during the pandemic, when companies took out debt and put cash on their balance sheets, akin to an insurance policy. They then chose to pay that debt down when the economy recovered more quickly than expected in 2021. Even before the chance for late-cycle re-leveraging in 2022, the US Federal Reserve started raising rates, so companies cut spending or dividends to protect their balance sheets further. The upshot now, I believe, is a strong credit story.

By contrast, with the yield spread for US BB high-yield bonds hovering around 1.8% to 2%, these valuations are less appealing.2 That said, we believe attractive opportunities exist in certain market sectors—notably energy, global banking, and some utilities—that are still pricing in disruption.

In my view, today’s investment landscape demands a nimble and dynamic approach to credit positioning. In particular, maintaining a higher level of dry powder while spreads are tight offers investors the potential to buy on dips when spreads are relatively more attractive.

Ready when markets reprice

To capitalise in this way, being selective across sectors counts. I favour issuers with sound balance sheets and positive fundamentals and then seek the security structure likely to benefit from capital appreciation relative to the downside risk.

Applying this approach, many parts of the US financial sector currently appear attractive and cheap compared to the market on a historical basis. Equally, I prefer taking more capital structure risk with a large US money centre bank rather than going down in quality with a US industrial. By contrast, I view high-quality 30-year credit as less appealing amid the significant supply squeeze in that part of the market, which is leading to trades at very tight levels.

Carving out resilient and consistent outcomes

Today’s more volatile backdrop is a timely reminder that investors cannot predict the market environment. However, they can control the process by employing a resilient and consistent framework to continually assess the upside and downside risks of every decision and possible price outcome.

By doing so, investors can seek to achieve a more all-weather total return experience and meet varied objectives through their credit allocation, for example:

  • As a return enhancer/diversifier to duration/liability-matching allocations within a fixed income growth allocation.
  • As a tactical complement to core fixed income and income/credit-focused allocations.
  • As a return-enhancing replacement for an intermediate credit allocation.

Above all, I believe that by assessing the range of potential outcomes based on changes in the forward path of interest rates, credit spreads and the broader economic environment, a dynamic and flexible approach to credit investing has the potential to achieve attractive total returns across a range of market environments.

To read more insights from Connor Fitzgerald, visit Wellington Management’s website.

1Bloomberg US Treasury Index, 30 September 2008 – 30 April 2024.
2The spread quoted shows the yield difference to Treasuries. Source: Bloomberg US BB high-yield Index.


The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The information presented contains forward-looking statements. Actual results and occurrences may vary, perhaps significantly, from any forward-looking statements made.

The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional or accredited investors only.

This is a sponsored article from Wellington Management.

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