Credit Where Credit Is Due: Four Common Misconceptions in Public and Private Credit Markets
Fear can trump discipline when markets become extremely volatile. In credit markets, the dramatic declines in the investment grade and high yield bond market so far this year understandably have unnerved many investors, and unfortunately, have given rise to potentially harmful misconceptions about risk and reward in the public and private markets.
As valuations begin to look attractive again, we at PIMCO have identified what we have determined to be four prevalent misconceptions circulating in the market that, if embraced, could potentially lead to poor investment outcomes.
Misconception #1: Returns in most public credit markets, such as investment grade and high yield, have been disappointing this year, and hence these asset classes are more risky
Nearly 80% of negative return in U.S. investment grade and high yield has come from interest rate moves this year as the market reacts to changes in central bank policy to address higher inflation (data according to ICE BofA corporate and high yield indices). At current valuations, where forward rates have reached close to neutral, having some high quality duration in addition to spread can be very advantageous to investors, in our view, particularly as the ongoing adjustment in global central bank policy rates helps to address the current high inflation. For investors worried about continued higher policy rates, duration risk can be hedged to various degrees while allowing investors to retain exposure to the credit risk. Current spreads – particularly in the higher-rated spread products like global investment grade and U.S. agency mortgages – have increased to levels well above their 20-year median levels in the U.S., offering compelling value over a long-term horizon, in our view, even as we recognize ongoing near-term volatility.Footnote1
Misconception #2: Bank loans are less risky than bonds
Syndicated bank loans may have less mark-to-market price sensitivity to interest rate moves because of their floating rate nature, but they still carry significant fundamental exposure to higher interest rates. Many issuers in bank loan and private credit markets issue floating rate instruments where the issuer is exposed to higher borrowing costs when interest rates rise. When issuers hedge some interest rate exposure, hedges are either partial or shorter than final liability, impacting borrowing costs when hedges expire.