PGIM Fixed Income Podcast Series, All The Credit: Episode 14
In this episode, Mike Collins, CFA, Senior Portfolio Manager welcomes three colleagues to discuss asset allocation in today’s markets.
During the depths of the March market meltdown, and as global central banks and fiscal authorities aggressively entered the fray, we saw the dawn of what PGIM Fixed Income believes to be “The Golden Age of Credit.” Decimated credit valuations, coupled with the belief that companies will be forced to finally prioritize debtholders, created a highly attractive entry point. Over the second quarter of 2020, fiscal and monetary stimulus surprised to the upside, global economies started to reopen, corporate issuance soared, stock indices skyrocketed, and spreads rallied furiously. This all begs the question: has the sun already set on “The Golden Age of Credit?” PGIM Fixed Income thinks it’s far from over; here’s why.
1. Attractive valuations. Timing is indeed everything. Entering the second quarter of 2020, credit spreads across virtually every rating category and maturity bucket were at the widest end of the range witnessed over the past 25 years. Although spreads have rallied since then, they have continued to trade at recessionary-type levels. The first leg of the credit spread rally 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 remains in the early stages in portions of the market that are still very much dislocated. In particular, the crossover corridor of BBB-rated and BB-rated corporate bonds appears attractive and is at the cheaper end of its historical range. In fact, dating back to 1994, BBB-rated corporates trade in the 87th widest percentile relative to A-rated corporates, while BB-rated corporates trade in the 81st and 83rd widest percentiles relative to BBBs and Bs, respectively.
Historically, in the repair part of the credit cycle, fallen angels in the crossover corridor represent a “gift from above.” 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. Of course, default and downgrade activity will pick up materially in the current environment, and credit selection remains paramount, but PGIM Fixed Income believes that spreads provide investors with more than adequate compensation for that risk. Paradoxically, when spreads are tight and defaults are low, credit returns are lower than when spreads are wide and defaults are high. Starting points matter and matter a lot.
2. Balance sheet repair. Credit investing is a perverse dark art where 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. This concerted effort that protects bondholder value is a favorable fundamental tailwind that naturally occurs when spreads are wider, not tighter. Even though leverage may temporarily spike with the decimation of second quarter earnings/cash flow, PGIM Fixed Income expects corporations to embark on this multi-faceted balance sheet repair march over the coming quarters and years. Provided that a company is a going concern (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, particularly considering the sharp and swift recession that created the leverage spike.
3. Slow growth is good growth. The unprecedented sudden stop in the global economy will likely have lasting effects on growth and the future economic trajectory. As PGIM Fixed Income’s Chief Economist Nathan Sheets recently discussed in Five Big Themes that Will Frame the Post-Virus Economy, the extent of the scarring is not completely known at this stage. And while PGIM Fixed Income believes that a U-shaped recovery is the most probable, alternate scenarios cannot be dismissed. Nonetheless, they see a long road back to trendline growth, which should keep corporations in free cash flow conservation mode for some time to come. In fact, the longer and harder the economic road to recovery, the more likely that companies will remain friendly to bondholders (or at least less hostile).
4. Too legit to quit. The global fiscal and monetary responses to this crisis have been nothing short of astounding. These often-coordinated, swift and decisive actions have arguably staved off the worst-case scenario for the global economy and, thus, the markets. Crucially, the current poor economic state is unlike the Global Financial Crisis where fiscal and monetary authorities were worried about “bailing out” bad behavior and actors. The current lack of villains strongly suggests that both governments and central banks will continue to do whatever it takes (to steal a phrase) to protect their innocent citizens. As such, PGIM Fixed Income doesn’t see either stopping until the so-called battle is won.
Risks are heightened as we progress through the second half of 2020, and we remain in an environment fraught with uncertainty. Understandably, investors prefer clarity and certainty. But once again, the near-term cloud should keep corporations conservative and focused on balance sheet repair. Admittedly, PGIM Fixed Income has less conviction over the near term as the markets will continue to be on a knife’s edge around geopolitics, COVID curves, and economic data. However, over the medium to long term, PGIM Fixed Income has a much stronger conviction as the current level of spread compensation, in concert with the strong fiscal/central bank response in a moderately low economic growth backdrop, bodes favorably for credit investing—thus enter “The Golden Age of Credit.”
This material reflects the views of the author as of July 23, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of July 23, 2020.
Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential mortgages. They are composed of a variety of loans, each of which represents different property sizes and locations. These loans are pooled and are broken into tranches of risk that are sold to investors. High yield bonds, known as junk bonds, are subject to a high level of credit and market risk. International bonds are bonds issued by foreign corporations or foreign government agencies. Emerging market bonds are local currency bonds issued by emerging market governments. Emerging market countries may have unstable governments and/or economies that are subject to sudden changes. These changes may be magnified by the countries’ emergent financial markets, resulting in significant volatility to investments in these countries. Investment-grade corporate bonds are bonds with a credit rating of AAA to BBB as rated by Standard & Poor’s, or Aaa to Baa as rated by Moody’s. Mortgages refer to mortgage-backed securities (MBS), which are composed of a variety of residential mortgage loans, each of which represents different property sizes and locations. These loans are pooled and are broken into tranches of risk that are sold to investors. Collateralized loan obligations (CLOs) are securities backed by a pool of debt, often low-rated corporate loans. Municipal bonds are tax-exempt bonds with a maturity of at least one year, including state and local general obligation, revenue, insured, and pre-refunded bonds. Unlike other investment vehicles, U.S. government securities and U.S. Treasury bills are backed by the full faith and credit of the U.S. government, are less volatile than equity investments, and provide a guaranteed return of principal at maturity. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. Past performance is no guarantee of future results.
The views expressed herein are those of PGIM Fixed Income investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. Neither Prudential Financial, its affiliates, nor their licensed sales professionals render tax or legal advice. Clients should consult with their attorney, accountant, and/or tax professional for advice concerning their particular situation. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional.
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