Rick Rieder and Jacob Caplain contend that with profound uncertainties still present in the economy and markets, and the dislocations witnessed in many market segments in the past couple months, investors don’t need to resort to lower-quality assets. In fact, to achieve potentially attractive returns, higher-quality spread assets can serve quite well.
The Covid 19-driven selloff created immense volatility and dislocations across fixed income markets. As investors de-risked their portfolios and sought liquidity at nearly any price during the selloff in March, opportunities were created for longer-term investors. Today, we believe that the fundamental outlook remains somewhat uncertain, as the economy, by and large, remains closed and the economic fallout from the government lockdowns has been severe. As the calendar turned in May, we began to see some hopeful signs regarding the course of the virus, which has been accompanied by immense monetary and fiscal stimulus. Given the significant amount of uncertainty ahead related to how all of this comes together, we think it’s still quite efficient today to take advantage of dislocations in fixed income markets by pursuing allocations to high- and mid-quality spread assets.
High/mid-quality spread assets attractive today
Today, across higher-quality fixed income, yield spread levels to comparable U.S. Treasury maturities are still near historically wide levels (see Figure 1). However, we think the opportunity today resides more in high and medium-quality spread sectors than in the riskiest assets, or in rate-heavy universes, such as the one defined by the U.S. Aggregate Bond Index. As displayed in Figure 1 below, the vast majority of the yield in corporate indices comes from spread risk today. Across all ratings cohorts, more yield comes from spread than from the risk-free component than we’ve seen historically. While spreads are also high in the Aggregate Index, less yield comes from spread and more from interest rates, which of course are historically low at present.
What’s happened in the past when spread makes up the majority of the yield in these indices? High and middle quality assets benefit. On average, the forward one year spread change in investment-grade corporate bonds is nearly 70 basis points (bps) tighter when spread/yield is above the 90th percentile; BB high yield spreads can tighten by as much as 125 bps in an environment where spreads are a large percentage of yield. At the other end of the spectrum in the rate-heavy Aggregate Index, spreads are tighter but by a competitively small amount—only 23 bps.
So, if spreads are so attractive—why avoid the riskiest and highest yielding assets? Isn’t there more return potential in the higher-yielding parts of fixed income? Perhaps, but we think that the risk/reward favors higher and medium-quality assets at this point in the virus progression and ensuing economic damage, particularly in certain industries and leveraged structures with uncertain levels of future cash flow. And, importantly, we think that the return potential of these assets is good enough that one can be satisfied with the returns available and that chasing excessive risks isn’t required to achieve attractive returns.