The Big Idea
Carry and correlation make a case for deep credit
Steven Abrahams | October 15, 2021
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.
Positive carry helped high yield and leveraged loans post some of the market’s best returns in the most recent quarter with some of its lowest volatility. Low correlation with other parts of the market also helped deep credit punch well above its weighting in portfolio diversification. It’s no surprise to investors managing broad debt portfolios through pandemic. Carry and diversifying correlation have been consistent parts of the credit story throughout.
The most recent quarter posted performance in major sectors of the debt markets that could stand in for most quarters of pandemic. Credit turned in the highest annualized rates of return in the third quarter across a range of levels of volatility. Leveraged loans delivered 4.40% annualized returns with volatility of only 0.46% (Exhibit 1). High yield debt posted 4.91% returns with volatility of 1.83%. And investment grade corporate debt printed 3.02% annualized returns with volatility of 4.58%. Other asset classes posted lower returns with volatility spanning roughly the same range as credit. Credit, in other words, delivered return more efficiently across all levels of risk.
Exhibit 1: Credit again posted leading returns, with deep credit showing low vol
Most of the differences in asset performance reflect differences in carry and in spread and rate exposure. In credit, for example, both leveraged loans and high yield corporate debt offered consistent OAS through the quarter of roughly 300 bp. But leveraged loans float over LIBOR and have almost no traditional duration while high yield debt has duration of around 3.9 years. The interest rate exposure added some return but most of the volatility of return to high yield. Investment grade debt carried at roughly 84 bp over the swap curve with duration of 8.7 years, the longest sector duration among major debt sectors. The rate exposure in investment grade debt added to return but also created most of the sector return volatility. Difference combinations of carry, spread and rate exposure created the return patterns in other assets (Exhibit 2).
Exhibit 2: Current duration and spread in major debt sectors
Except for the quarter including March 2020, this pattern of relatively efficient performance in deep credit has broadly repeated itself each quarter since. The steady outperformance of deep credit has led to strong cumulative returns. After plunging in March 2020, the value of $1 invested in the high yield index at the end of 2019 stood by the end of September this year at $1.120 (Exhibit 3). A dollar invested in investment grade corporate debt stood at $1.085, in leveraged loans and private CMBS at $1.077, in agency CMBS at $1.076, in Treasury debt at $1.053, in ABS at $1.048 and in agency MBS at $1.032.
Exhibit 3: All major debt asset classes have recovered from March 2020
Deep credit has also posted low or negative correlation with more rate-sensitive sectors for understandable reasons. Day-to-day changes in market views of economic growth tend to drive rates higher while tightening credit spreads, pushing performance of rates and credit in opposite directions. High yield and leveraged loan showed small negative correlation with other sectors in the most recent quarter (Exhibit 4). In past quarters, these sectors showed low positive correlation to other sectors. Returns in more rate-sensitive products, on the other hand, continued to show high correlation with each other. The pattern of correlations suggests most sectors of the debt markets offer only slightly different exposures to rates while the dominant credit component of high yield and leveraged loan returns strongly diversifies debt portfolio rate exposures.
Exhibit 4: Both high yield and leverage loans showed modest negative correlation with sectors more weighted to traditional interest rate risk
Realistically, portfolio constraints will limit investors’ ability to own deep credit. Banks will largely take credit risk in their loan portfolio. Insurers will continue to take modest deep credit exposure. Some mutual fund managers and managers of other total return accounts will operate against guidelines that rule out high yield or leveraged loans. But other portfolios will have flexibility.
The current state of corporate balance sheets is healthy, so a large share of even leveraged balance sheets are stronger than usual. Earnings have been near record levels for many companies, margins have been high, debt-to-EBITDA and EBITDA-to-interest-expense ratios have been manageable and balance sheet liquidity has been above average.
Some clear risks to deep credit come from current and potential future effects of monetary and fiscal policy. Companies generally have been able to manage expenses down and pass along inflation so far, but any customer resistance to higher prices could compress margins and profits. Most pandemic relief programs have ended by now and consumers should eventually spend down the substantial savings built up since March 2020, which could soften consumer demand. And if inflation persists to the point of triggering Fed hikes to control it, the Fed has a record of tipping the economy into recession.
Of course, in circumstances where deep credit fundamentals deteriorate and spreads widen, the more rate-sensitive parts of a diversified debt portfolio should perform well. If margins compress and the economy slows, rates should do well. If consumer demand softens and the economy slows, rates should do well. And if the Fed tightens to the point of tipping the economy into recession, rates should do well.
The latest quarter of returns and the outlook for credit fundamentals and policy still make a case for staying overweight deep credit as a source of carry, return and diversification.
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The view in rates
The Fed RRP continues to soak up a healthy amount of system liquidity. After peaking at $1.6 trillion on September 30, it is closing Friday at $1.462 trillion, up $90 billion over a week. The recent rise in rates has left RRP yields of 5 bp now below the yields on T-bills beyond November. It will be interesting to see if that draws some liquidity out of the RRP.
Settings on 3-month LIBOR have closed Friday at 12.225 bp, a level toward the middle of the recent range. LIBOR clearly is trading with an eye on transition to other benchmarks by June 30, 2023. All interdealer swap trades will use SOFR by October 22, with dealers, banks and others urged to create no new LIBOR exposures after December 31 this year.
The 10-year note has finished the most recent session at 1.57%, down 4 bp from a week ago. The market has been absorbing the FOMC and its intent to taper and hike, and it has been reassessing inflation. Breakeven 10-year inflation is at 256 bp, up 19 bp in the last two weeks and nearly equal to its peak this year in May. The 10-year real rate finished the week at negative 99 bp, down from negative 92 bp two weeks ago.
The Treasury yield curve has finished its most recent session with 2s10s at 118 bp, flatter by 2 bp over the last two weeks, and 5s30s at 92 bp, flatter by 18 bp on the week.
The view in spreads
The bullish case for credit and the bearish case for MBS continues. Corporate and structured credit has held spread through most of the year despite the steady approach of Fed tapering. MBS, on the other hand, generally widened from the end of May before starting to tighten after the September FOMC.
The difference is partly in the composition in demand across the sectors and in strong corporate fundamentals. The biggest buyers of credit include money managers, international investors and insurers while the only net buyers of MBS during pandemic have been the Fed and banks. Credit buyers continue to have investment demand. Demand from Fed and banks should soften as taper begins, Once the Fed shows it hand on the timing and pace of taper, the market should be able to fully price the softening in Fed and bank demand and spreads should stabilize. But something else is on the horizon.
MBS stands to face a fundamental challenge in the next few months as the market starts to price the impact of higher Fannie Mae and Freddie Mac loan limits. Home prices are tracking toward a nearly 20% year-over-year gain, which should get reflected in new agency loan limits traditionally announced in late November for loan delivered starting January 1. The jump in loans balances should add significant negative convexity to the TBA market and increase net supply. And this will come just as the Fed leans into tapering, which will take out a buyer that often absorbed the most negatively convex pools from TBA and a large share of net supply. The quality of TBA should deteriorate and the supply swell.
The view in credit
Credit fundamentals continue to strengthen. Corporations have record earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. The consumer balance sheet now shows some of the lowest debt service on record as a percentage of disposal income. That reflects both low rates and government support during pandemic. Rising home prices and rising stock prices have both added to consumer net worth, also now at a record although not equally distributed across households. Consumers are also liquid, with near record amounts of cash in the bank. Strong credit fundamentals may explain some of the relatively stable spreads.