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Credit comes back in the first quarter

| April 5, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Credit investors may have held a bad hand late in 2018, but they have more than made up for it so far this year. Returns through March on investment grade and high yield credit and on leveraged loans have fully rebounded from late last year and added a little extra. Treasury debt and MBS have shown strong performance through both periods. Just as importantly, the diversification benefit of blending high yield or leveraged loan exposure with MBS continues to look compelling.

Strong returns in credit, stable returns in MBS and rates

Credit opened 2019 with a strong quarterly performance. Investment grade corporates delivered a 20.6% annualized return, high yield a 28.8% annualized return and leveraged loans a 16.0% annualized mark (Exhibit 1). MBS provided a 8.8% annualized return with Treasury debt only slight behind at 8.6%. The first quarter returns reflected falling interest rates and tightening spreads across credit and MBS.

Exhibit 1: Returns on IG, HY and leveraged loan credit rebounded strongly from late last year

Source: Annualized daily returns on Bloomberg/Barclays indices for Treasury, MBS, IG and HY, S&P/LSTA index for leveraged loans. Calculations by Amherst Pierpont Securities.

The strong performance in credit completely made up for losses in the last quarter of 2018. Even though interest rates generally fell that quarter, wider credit spreads more than offset the effect of lower rates. Investment grade credit lost an annualized 0.7% late last year, high yield an annualized 18.9% and leveraged loans an annualized 14.3%. MBS in the last quarter of 2018 returned an annualized 8.5% and Treasury debt an annualized 10.4%.

A continuing pattern in the volatility of returns

The volatility of returns across asset classes this year continues to echo earlier results (Exhibit 2). MBS and leveraged loans showed the lowest annualized volatility, just as they had in the last quarter of 2018. Leveraged loan returns have shown the lowest volatility among major asset classes in three of the last four quarters. Relatively lower average duration and negative convexity dampen return volatility in MBS, and floating coupons dampen return volatility in leveraged loans. Treasury debt and investment grade and high yield corporate debt tend to show higher volatility because of greater sensitivity to changing interest rates.

Relatively high returns and modest risk combined in the first quarter to give credit the highest return-per-unit-risk. The ratio of return to risk in high yield during the first quarter came in at 8.46, in investment grade at 6.38 and in leveraged loans at 5.78. MBS delivered 3.78 and Treasury debt 2.56.

Exhibit 2: MBS and leveraged loans often show low-to-modest return volatility

Source: Annualized volatility of daily returns on Bloomberg/Barclays indices for Treasury, MBS, IG and HY, S&P/LSTA index for leveraged loans. Calculations by Amherst Pierpont Securities.

Correlations signal relative sensitivity to rates and spreads

Correlation between returns on different assets remained broadly consistent in the first quarter, too, including the diversifying impact of high yield and leveraged loans (Exhibit 3). Treasury, MBS and investment grade corporate returns showed correlations ranging between 0.84 and 0.94. High yield and leveraged loans showed a correlation of 0.80. But correlations between more rate-sensitive and credit-sensitive assets ran from -0.22 to -0.45.  Strong correlation within rate-sensitive and credit-sensitive groups and negative correlation between the groups shows up in results for the last four quarters, too.

Exhibit 3: Strong correlation within rates and credit assets, negative correlation between rates and credit

Source: Correlation of daily returns on Bloomberg/Barclays indices for Treasury, MBS, IG and HY, S&P/LSTA index for leveraged loans. Calculations by Amherst Pierpont Securities.

The correlations arguably point to different responses across assets to broad economic news. Strong news sends rates higher and returns rate-sensitive assets lower. But the same strong news should tighten spreads in the most credit-sensitive assets. The strong correlation between returns on Treasury, MBS and investment grade corporate debt highlights the greater impact of rates rather than spreads on these sectors. Investment grade credit looks more like a rate than a credit asset. The negative correlation of these assets with high yield and leveraged loans shows the relative importance of spread in the credit assets.

Potential gains from diversification

The negative correlation between rates and credit, assets, if it persists, offers important opportunity to reduce portfolio risk without necessarily hurting return. For example, a hypothetical portfolio with 55% MBS and 45% high yield would have shown a 5.07% return for the year ending in March, roughly half-way between the 4.4% return on MBS and the 5.9% return on high yield (Exhibit 4). The risk on the combined position, however, would have run well below the risk on either asset alone. A portfolio of 44% MBS, 26% high yield and 30% leveraged loans would have matched MBS returns last year but again with much lower volatility. And a portfolio of 42% MBS and 58% leveraged loans would have delivered a blend of return but again with much lower risk.

Exhibit 4: Blending rate and credit assets may significantly dampen portfolio risk

Note: MBS+HY = 55%MBS + 45%HY; MBS+HY+LL=44%MBS+25%HY+30%LL; MBS+LL = 45%MBS + 58%LL. Source: All results based on daily returns on Bloomberg/Barclays indices for Treasury, MBS, IG and HY, S&P/LSTA index for leveraged loans. Calculations by Amherst Pierpont Securities.

Asset prospects

Return prospects for credit continue to look reasonable even though leverage in investment grade is relatively high and underwriting standards in leveraged loans continue to slip. Both sectors will likely have to adapt to slowing US and global economic growth. A growing list of investment grade companies has nevertheless picked up efforts to pay down debt, sell non-core assets and find other ways to deleverage. Investors in leveraged loans or CLOs can protect themselves by looking for assets with limited exposure to retail, software and services and other sectors without hard assets or saleable components of their business.

MBS looks likely to do well against Treasury debt mainly because of the expected net supply of nearly $1 trillion in Treasuries projected for this year and next. Ample Treasury supply tends to narrow spreads to other parts of fixed income.

Prospects for Treasuries look the weakest. The rates market has priced for at least one Fed ease over the next two years and for rates of growth below potential. The Fed may ease to protect growth, but growth is likely to surprise to the upside.

Go overweight MBS and add exposure to high yield, leveraged loans, CLOs or related credit.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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