Generating returns in an environment of low credit spreads | Insight Investment

Hello, my name's Andy Burgess and today we are going to be exploring how investors can look to generate returns in an environment which is exhibiting low credit spreads and yet the significant amounts of macro volatility.

So let's just check that we are in that environment first. Are we really in a low spread world?

Well, if we look at credit spreads for investment grade quality corporate debt, then the answer is unequivocally yes we are. It'd be a very short presentation if we weren't I guess. But these charts show that credit spreads are back to post GFC tight, so going all the way back to 2008 and that's just in sterling. If we look globally, it would exhibit a very similar picture.

Now, part of that as we'll explore is due to, you know, robust economic growth, strong demand for fixed income, all leading to a positive environment for corporate debt. And that excess demand for corporate debt has indeed driven spreads back towards their post GFC tights.

And what about volatility? Are we really in a more volatile world?

Well again, it feels that way looking at the headlines that we're all exposed to on a day-to-day basis. And indeed the changes in brought around by the new US administration early this year largely around tariffs have brought back that feeling of increased headline risk and volatility.

But trying to examine that in a formal way. We look at US treasuries and the volatility in US treasuries as a proxy. You can see that after over a decade of low volatility, largely driven by low and stable levels of interest rates, central banks buying underlying assets, all of these factors have kept market volatility at artificially low levels since we saw government bond yields rise sharply in 2022. However, we've returned to a more normal level of market volatility.

So I think we can say without a doubt, although very recently volatility has dipped, actually we are back to a much more normal level of volatility, but not a very volatile world, just a more normal level of volatility.

Now is that really bad for credit assets?

Well actually, although I've shown you a chart that explained that investment grade credit spreads are pretty tight, I'm not here to tell you that they're a bad investment either. Credit still more than compensates you for the level of fundamental risk of losing money IE default risk.

Now the chart, the left hand side here shows you the credit spread you get for single A and triple B rated corporate bonds in a variety of different markets. So investment grade quality credit, but then it takes away the amount of that spread that you need to compensate you for companies defaulting on their debt. And you can see that even in a normal market environment, credit spreads more than compensate you for default risk.

Now we're likely to be in a normal, a median level of defaults, but those numbers are still positive even if we were to enter a relatively stressed period for default risk. So fundamentally, should you make money over government bonds by an investment grade credit, the answer is definitely yes.

If history is any guide on top of that, we've got the higher level of volatility, fixed income markets and notoriously inefficient active approach to selection, whether it be across government bonds or corporate bonds. Investment grade or lower quality high yield bonds show that over time an average active manager outperforms the market. And when we look at more recent periods where volatility is higher, that outperformance has been greater.

So active approach to managers by managers can indeed enhance the level of return you're getting over and above the spread or the yield that the asset class offers. So my job here today really isn't to tell you that investment grade credit is bad, but just to explain, maybe there's some opportunities out there that you could consider to exploit or to compliment your existing investments.

Now, what approaches should you consider?

Well, here's a couple of options. Firstly, you could think about targeting a more attractive credit market. Is there an area of the credit universe that offers a higher level of return for similar levels of risk? And we think there is the asset backed market.

Now here you are looking to exploit what we call complexity premium. So additional return driven by the additional work an asset manager needs to do to get through the complex asset class to deliver a level of return. And that means exploiting more esoteric parts of the credit market.

But by looking at this asset class, you can potentially enhance your returns without taking any more fundamental credit risk.

The second opportunity we'll look at is maybe exploiting that heightened level of market volatility I mentioned, but removing the directional bias or risk that you have from traditional long only strategies. So maybe looking at an absolute return approach to investment.

Here you can benefit from the two way movements in markets, so positive and negative markets, but also exploiting the fact that not only are we in a higher level of volatility at the moment, but that we feel that volatility is very much here to stay.

Now taking asset-backed markets first.

Now asset-backed markets are very attractive in our view, but unfortunately they don't have market indices to show you market levels. So what we've shown here is a number of different strategies that Insight manages at different parts of the credit risk spectrum in asset-backed securities.

The dark green line here shows the credit spread from investment grade short dated corporate bonds, the sterling one to five year index and compares it to a number of different segments of the ABS market.

The light green line, the triple A line represented by a equal ABS strategy does trade at a lower spread than investment grade corporate bonds, but is materially higher in credit quality. You are moving from single A triple B credit risk, so the lowest level of investment grade quality to the highest level of credit risk that you can either the highest credit quality that you can and you're sacrificing a small amount of return or spread for moving materially higher up the credit risk spectrum.

The light blue line, however, the high grade ABS strategy, so a mix of triple A and AA rated ABS assets offers a slightly higher spread than single A triple B corporate bonds. Here you're improving both the credit quality and the return potential of your investments.

When you move further down the credit risk spectrum to the orange line or even to the dark line of the secured finance strategy, that extra spread increases even further.

Insight is shortly launching an enhanced ABS strategy, which will sit in that shaded line in between the light orange and the dark line, which will be a similar credit quality to the sterling corporate bond market. So you can see there's a material complexity premium you can exploit and take advantage of within the ABS market.

Now what are asset backed securities or ABS and how do they differ to corporate bonds?

These are bonds or securities that are referenced to or secured against a ring set of cash flows or underlying assets. Things like residential mortgages, commercial mortgages, car loans, student loans and the like.

They typically pay a return over and above cash. Their coupon or interest payments are linked to cash rates, so they're not reacting in the same ways as corporate bonds will to movements in longer dated government bond yields such as gilt yields. They're also relatively shorter dated.

Now the benefit of that is means that they're less volatile than the fuller maturity part of the corporate bond market. That means that even if spreads widen, they typically rally back more quickly as long as you don't see material changes in credit quality.

The ABS market, it's also typically higher quality as we've already seen in the corporate bond market. The biggest part of the ABS market is the AAA segment, which is completely different to the risk spectrum and the risk distribution within the corporate bond market.

Now lastly, we've already seen a chart on this. The complexity premium this asset class offers means you can enhance your return without increasing credit risk.

Now these factors combined are one of the many reasons why investors are considering this asset class, either as a standalone investment or indeed as part of their collateral waterfall within a risk management solution.

Now I mentioned that they're backed by assets, ring-fenced assets away from the balance sheet of the originating entity and we broadly divide these assets up into three types, residential and consumer assets, so residential mortgages, auto loans, credit cards or consumer loans where your pool of assets that you're relying on to pay back in order to make sure your bonds can give you the money you are expecting are driven by the credit quality and the repayment of thousands of underlying individual borrowers.

The second area is commercial real estate where the bonds are backed by loans secured against offices, retail parks, logistics centers or warehouses or indeed hotels and other leisure assets. These are more cyclical and more concentrated in nature and typically form smaller parts of ABS portfolios.

The last part is corporate risk. You may have heard acronyms such as CLOs, collateralized loan obligations. These are simply underlying bonds that are backed by pools of corporate loans typically to lower quality or high yield companies. One might also be called what's called whole business securitizations such as pub securitizations.

These three types of underlying asset type are essentially the main parts of the ABS market and portfolios allocate between these three types of collateral but also globally between different markets such as the US, the UK, Europe and Australia.

Now how do you understand and get to the bottom of the credit risk you're exposed to within this more complex to analyze type of asset?

The first step is to understand who is making the decision to lend money? Who is the borrower? What is their credit quality?

Now if the underlying borrower such as the homeowner or the car buyer doesn't default on the loan, well then bond investors get their money back. But if the borrower, the ultimate borrower defaults then you often have protection from the underlying asset that the bonds secured against. So the property or the car.

So understanding and analyzing that asset is an important part of understanding the level of protection that you'll have.

The third part is whether or not there's additional protection within the bond structure. This might be more junior bond holders or indeed what's called a reserve fund or equity within the structure that takes losses first before bond holders.

This can often be material within a residential mortgage backed security, for example. You could have protection that could absorb everybody defaulting in this pool of underlying borrowers and house prices falling between 40 and 50% before senior bond holders take losses.

So understanding how much protection you have between the borrower quality, the value of the asset and the bond structure is very important and it's important to stress test that to make sure you understand how well protected you are if things do go wrong.

And then lastly, as a credit asset, it's identifying the best value across global markets, taking into account the varying credit risk profiles across each jurisdiction and asset type.

So that's one option for investors to consider, asset-backed securities exploiting that complexity premium on offer.

What about a different approach exploiting the very fact that we're in a more volatile environment in a two way fashion? So exploit volatility and make it work in your favor considering an absolute return approach.

Now firstly, it's important to think about, well, is this the right environment to think about an absolute return approach?

And we've considered historically four key factors that we think can indicate whether that's true or not.

The first is an absolute return approach tries to generate a return above cash. So the higher the level of cash rates, the more attractive an absolute return approach would be versus other asset classes.

This looks at European cash rates, but the picture is very similar in the sterling market. In fact, globally cash rates having increased significantly over the last few years and although they're slightly off their peak, they're still relatively high compared to long-term averages.

So a tick there.

Secondly, you could consider investing longer dated versus an absolute return approach. So the shape of the yield curve matters. If you can get a materially higher return by investing in longer dated or higher duration assets, well that's not such a good environment for an absolute return approach.

However, we are not in that environment at the moment. We're an environment with a relatively flat yield curve, certainly when we look at it on a global perspective.

So again, a flat yield curve relatively positive for an absolute return approach.

Thirdly, the more volatility we have in markets, the more opportunities investors can exploit. When we consider volatility indices, again, a similar picture emerges in a relatively high volatility environment back to pre GFC levels of we've already seen.

And then lastly, if there's less market beta IE credit spreads are tighter, well then market direction isn't going to yield you an easy way to generate returns.

And again, four pluses on each of these indicators. When we blend all of these together to get an absolute score, well actually we work out we are nearly the 94th percentile as at the end of May of where we are. When we update that as well to more recently, it's still a very attractive regime at the moment.

You can see post GFC to the end of 2021, 2022, it was not a good environment for an absolute return approach given the higher level of market volatility, higher cash rates, lower spreads, and increased levels of general headline risk. All of these factors lead to suggest a more positive environment, a supportive environment for an absolute return approach.

Now how can you exploit this environment?

Well, the first thing is to have no structural risk bins. Start from zero and only invest where you have an exploitable idea that's going to generate a positive return, but not be biased in your investment process to one part of the market or another.

The second, be able to respond to different opportunities to take advantage of both top down opportunities and bottom up driven opportunities. So both larger macroeconomic and market themes and individual company and bond by bond opportunities.

By exploiting these opportunities in a risk controlled way, it's possible to generate strong but consistent risk adjusted returns.

And this also means if you remove structural biases, you have a top down and a bottom up process, well then you should be able to generate a positive return or alpha in all sorts of different environments.

Lastly, a broader opportunity set is an attractive characteristic for a well run absolute return strategy.

You can exploit opportunities across government bond markets, both in conventional and inflation linked space, developed markets, as well as emerging markets. Within credit markets, you can exploit investment grade, high yield loans or more esoteric parts of the market like the asset-backed market we looked at earlier.

Balancing both the ability to access market beta if it's available or bottom up alpha generation across the broadest fixed income opportunity set enables investors to benefit from this type of approach and potentially enhance returns above cash by two to 3%.

Now I mentioned top down and bottom up and here's a graphical representation of the different types of return drivers.

If you do have a strong view that markets are heading in one direction or another, and it can be in either direction, well that's something you can exploit. You can have credit risk, you might go long interest rate risk or short interest rate risk and benefit from yields rising, for example.

Secondly, you could look at relative value between markets such as between global government bond markets such as the UK versus the US or Australia versus New Zealand, for example. Or you could look at between credit markets. So the spread between European and US investment grade for example, or high yield versus investment grade.

These are all top down market driven value opportunities that you can exploit.

But there's also lots of bottom up types of opportunities. That could be between different segments or different bonds within a global government bond market. It could be between sectors such as banks versus utility companies or indeed and probably most reliably across all four quadrants is bottom up issuer analysis, researching companies understanding the credit risk and where it's most mispriced in the market and getting exposure to those companies that you feel are going to outperform and avoiding exposures to companies that you think have material downside risks.

And varying your risk exposure across these four areas means you should be able to identify and exploit attractive opportunities across different market environments.

Now just to show a bit of proof to that statement, if we consider going back to 2022 when global government bond and credit markets fell more than 10% in value over the course of that year, an absolute return approach such as that bonds plus strategy generated a positive return, but also a much smoother path of returns because it's investing and exploiting both positive and negative views of markets.

And although it's exclusively investing in fixed income markets with a small allocation to relative currency positions, it's almost completely uncorrelated to other fixed income asset classes and even other asset classes such as equities.

And that means an absolute return approach can not only generate attractive returns but do so in a very diversifying lowly correlated way with some of your other assets and can therefore prove to be an important diversifying asset class or return generator as part of a broader portfolio.

So to summarize, yes, we are back in a more volatile environment and yet credit spreads certainly within investment grade corporate bonds are back towards the tighter levels we've seen post the GFC.

Now there's no need to panic. Investment grade credit is still very useful. You're still more than adequately compensated for default risk and it's still a very useful asset class to generate cashflow profiles should you need them.

But there are attractive alternatives out there for you to consider. Asset backed markets offer a complexity premium, a higher level of spread for either the same or lower levels of credit risk and maybe considering a different approach such as an absolute return bond approach could provide a diversifying and low correlated way to generate cash plus type of returns.

Thank you very much for listening to this and I hope if you do have any questions, please don't hesitate to contact your inside representative.