Lessons learned in corporate credit in 2021 Part II

Dan Bruzzo, CFA | December 17, 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.

We recently published our outlook laying out our expectations for the corporate bond market in 2022 (APS Strategy: Corporate Outlook 2022). Before we enter the new year, we thought it would be an effective exercise to look back at some of the market calls we made over the past year and see how those recommendations panned out in the following months. By examining what worked and what did not, we can better shape our expectations for the coming year and refine our strategies that we think will give investors the best opportunity for outperformance.

#1 M&A matters

M&A proved very active in 2021, particularly among banks with total assets between $20 billion and $75 billion, and occasionally up to $100 billion. The most likely candidates fit a clear profile. Liquidity in these outstanding debt issues does remain an obstacle for investors actively seeking to play this trend. However, the additional spread that is available over the investment grade large US regional banks is still highly compelling when bonds do become available. The sector still has plenty of capacity for further consolidation in 2022, and heightened M&A remains a strong macro calls for the corporate bond market in the coming year.

#2 The NAIC matters

The market in July started focusing on coming changes in NAIC capital rules. For roughly 30 years, the NAIC has used a 6-point designation for assigning risk to fixed income securities. The NAIC has long been considering an expansion to a more granular system of approximately 20 ratings notches, which would impact the risk-based capital charges of many fixed income securities held by insurance companies. The proposed changes should affect some rating notches more than others—specifically the A3 and BBB3 rating levels. Insurance companies might begin to rotate bond holdings to reflect the fact that lower-rated bonds would now carry greater risk-based capital charges. With insurance companies holding roughly one third of the $10.6 trillion in outstanding US corporate bonds, it stands to reason that any trends in that sector could have significant impacts on valuation across the entire market. So far, these impending changes have not had an observable impact on valuation between the various rating notches in the corporate bond market. While this does not rule out this trend becoming a bigger consideration as the changes come closer to implementation, this was clearly not a priority for insurance company portfolio managers in 2021.

#3 It helps to play insurance company surplus notes

Throughout much of 2021, investment grade corporate bond investors sought out strategies to maximize spread compensation, demonstrating a willingness to move out the credit curve or seek the highest yielding opportunities in any given segment. More recently, however, the market has demonstrated greater risk aversion, with investors targeting up-in-ratings trading strategies and more preference for stable credit opportunities. Few segments of the market would be considered to fall in both of those categories, insurance company surplus notes could fit either description. Insurance company surplus notes let investors move up in ratings while still adding spread over lower-rated notes issued at the senior unsecured level of comparable issuers. Many of these structures contain AA ratings, as they are operating company obligations, often subordinated only to policyholders in the capital structure waterfall. Because they are considered a form of hybrid capital and are often less liquid than comparable senior unsecured securities, they have historically traded wider than their high ratings would imply.

#4 Theory may not work in reality

In 2021, the Fed began to unwind its $13.77 billion portfolio of corporate ETFs and bonds that it began accumulating in 2020 in an effort to help backstop and prop up the corporate credit markets. The individual bonds held were investment grade, non-bank credits in the front-end of the curve with maturities under five years. It was our observation that in some cases, the Fed held a very high percentage of bonds outstanding relative to the amount of those bonds that were actually trading in the secondary market. It was our expectation that as the Fed began liquidating these positions that it could put pressure on valuation, with what equates to a large, forced seller of bonds that often had very limited liquidity. We developed “pressure scores” to help identify the bonds that were most likely widen as the Fed unwound its large positions in the securities, and even provided swap candidates into similar sector/maturity bonds that had greater liquidity and could be less influenced by the Fed’s outstanding position. While conceptually accurate, these swaps proved extremely difficult to pursue in the secondary market. Furthermore, investors appeared unwilling to sell front-end positions, either due to higher book yields or the lack of viable options to effectively put money to work, even with the risk of near-term spread widening in a particular CUSIP. Again, while the exercise helped raise awareness to the issue and generated some compelling conversations about valuation, the challenge of execution proved too difficult for investors to take advantage.

#5 Get paid to give up some liquidity

Hit: Precapitalized securities offer attractive spreads

Precapitalized securities or P-CAPs are a unique trust structure used selectively by insurance companies seeking to issue debt, but also wanting to keep leverage off the balance sheet until or if the funds are eventually needed. The bonds have traditionally traded in the secondary market at a sizable discount to comparable senior unsecured debt issued by the same insurance companies. It has been our view that investors are well compensated for the moderate give-up in liquidity and structural implications associated with these securities. In a year when spreads mostly ground tighter throughout the first three quarters, the additional yield in these structures served investors well. In the second half of 2021 there were two new P-CAP issues in the investment grade market (LIFEVT, UNM), demonstrating that the structure is still being viewed as useful to issuers and well accepted by investors.