Is credit worth the risk?


Jonathan Platt, Head of Fixed Income

 27 October 2016

It’s sometimes easy to overlook the very basic investment premise behind corporate bonds; a company is more likely to default than the government, and this credit risk means you get a higher yield. This is the credit spread – an additional return over and above that on a government bond.
Until 2008, the additional yield on a high quality, investment grade bond was around 0.50%. The financial crisis was obviously going to lead to strains on corporate earnings and hence an increase in defaults. However, credit spreads blew out to an eye-watering 4.50% – a level that implied bankruptcies on an almost catastrophic scale. This represented a terrific opportunity for credit investors, and many, including RLAM, took full advantage. Since then, the speedbump of the euro crisis aside, spreads have steadily decreased as investors have grown more confident in the strength of the corporate sector with increased demand for yield also helping spreads tighten.
Today, that spread is around 1.30%. Expensive compared to the last few years? Good value on a pre-crisis basis? Both cases can be made – but does it compensate you for current default risk? We’d argue it does. We look across the investment grade universe, adjusting our ‘fair value’ assessment for different recovery levels. If we assume that the recovery rate is zero – in other words, that there are no assets to pay creditors any money at all – we would want around 0.40% to compensate for the default risk. That means we feel that at an index level, we are getting paid around 0.90% of excess risk-adjusted return. Intuitively this feels right – after all, even with Brexit uncertainty, no-one is predicting a complete meltdown of the UK economy, so the risk of high quality companies going bust leaving no assets for creditors is relatively low.
And we believe we can do better than the market spread. Because there is an excess return available, we prefer to largely ignore the supranational bonds that make up a large part of the index but have a very low credit spread. We prefer to invest more in secured bonds that have an attractive spread and a first call on defined assets so that even if the company defaults, we have confidence that recovery rates will be materially higher than on unsecured bonds. With around half our portfolios in these secured assets, and near zero exposure to supranationals, we think we can target a credit spread of around 2%, without compromising on security.

It’s sometimes easy to overlook the very basic investment premise behind corporate bonds; a company is more likely to default than the government, and this credit risk means you get a higher yield. This is the credit spread – an additional return over and above that on a government bond.

Until 2008, the additional yield on a high quality, investment grade bond was around 0.50%. The financial crisis was obviously going to lead to strains on corporate earnings and hence an increase in defaults. However, credit spreads blew out to an eye-watering 4.50% – a level that implied bankruptcies on an almost catastrophic scale. This represented a terrific opportunity for credit investors, and many, including RLAM, took full advantage. Since then, the speedbump of the euro crisis aside, spreads have steadily decreased as investors have grown more confident in the strength of the corporate sector with increased demand for yield also helping spreads tighten.

Today, that spread is around 1.30%. Expensive compared to the last few years? Good value on a pre-crisis basis? Both cases can be made – but does it compensate you for current default risk? We’d argue it does. We look across the investment grade universe, adjusting our ‘fair value’ assessment for different recovery levels. If we assume that the recovery rate is zero – in other words, that there are no assets to pay creditors any money at all – we would want around 0.40% to compensate for the default risk. That means we feel that at an index level, we are getting paid around 0.90% of excess risk-adjusted return. Intuitively this feels right – after all, even with Brexit uncertainty, no-one is predicting a complete meltdown of the UK economy, so the risk of high quality companies going bust and leaving no assets for creditors is relatively low.

We believe we can do better than the market spread. Because there is an excess return available, we prefer to largely ignore the supranational bonds that make up a large part of the index but have a very low credit spread. We prefer to invest more in secured bonds that have an attractive spread and a first call on defined assets so that even if the company defaults, we have confidence that recovery rates will be materially higher than on unsecured bonds. With around half our portfolios in these secured assets, and near zero exposure to supranationals, we think we can target a credit spread of around 2%, without compromising on security.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.