Few people will have a difficult time watching the calendar flip past 2020. The reality, however, is that 2021 will no doubt bring its fair share of uncertainty as well, whether it be ongoing pandemic worries, geopolitics or an economic backdrop that remains unpredictable.
Those near-term concerns are likely to keep corporations conservative and focused on improving their balance sheets. And over the long term, the continued support of fiscal policy and central banks around the world, in a moderately low economic growth backdrop, tends to bode well for credit investors.
We call it the Golden Age of Credit, and it has a handful of powerful drivers:
- Attractive valuations: While spreads have recovered from their recent wide levels, they still offer long-term value. The first leg of the credit spread rally in 2020 featured assets that were directly targeted by various support programs, namely high-quality assets. For example, AAA-rated securitized products and high-quality, shorter-duration investment-grade corporate bonds rallied strongly and largely recovered. However, the second leg of the spread recovery still has room to play out in some portions of the market. In particular, the credit crossover corridor of BBB and BB appears attractive. Historically, in the repair part of the credit cycle, fallen angels in the crossover corridor represent a “gift from above,” and segmentation in the fixed income markets is particularly acute in the crossover corridor, which subsequently creates a meaningful source of potential alpha for multi-sector investors. Default and downgrade activity could pick up materially should the economic environment deteriorate, and credit selection remains paramount, but we believe that spreads still provide investors with more than adequate compensation for that risk.
- Balance sheet repair: Credit investing is a rare world in which not-so-favorable news can improve the investment outlook. Essentially, credit investors benefit the most when companies are in free cash flow conservation mode and they pull back on balance sheet destructive activities, such as share repurchases, dividends, and capital expenditures. We expect corporations to embark on multi-faceted balance sheet repair over the coming quarters and years. Provided that a company doesn’t default, of course, the direction of a credit’s travel may actually be a better determinant of its performance, rather than simply assessing the current state of its credit profile.