Uncategorized

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.

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
john.killian@santander.us
1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

The Library

Search Articles