Insights

A common theme in 2024 has been ongoing demand for corporate bonds. As to be expected, institutional investors have favoured higher quality investment grade bonds, but demand for sub-investment grade (high yield) and private credit has also been strong.

Perhaps this should be of no surprise. Interest rates have peaked in the developed world and are starting to fall in many major economies. This offers the potential for near term capital gains on an asset class already offering an attractive level of income. The average coupon on corporate bonds is at the highest level in roughly five years.

Furthermore, forecasts for a hard economic landing have moderated and inflation appears under control.  So, if you are in the camp that foresees a soft landing (or no landing), then corporate credit makes a great deal of sense. Higher quality issuers should easily withstand a mild downturn in economic activity and any reversal of recent interest rate hikes should be good for investors – bond yields down, bond prices up.

But perhaps the forecast soft landing turns into a nasty fall, or some other variable causes a sell-off in risk assets. According to the Peace Research Institute of Oslo, 2023 saw the highest number of state-based conflicts since 1946 and current tensions in the Middle East and Ukraine could easily escalate. The political landscape is becoming more fractured, with centrist parties increasingly replaced by those on the far left or far right and the threat of increased government spending as politicians attempt to woo voters.

Defaults within the corporate bond market remain modest, but with many issuers taking advantage of the low interest rate environment to borrow, there are growing concerns around refining risk, particularly for bonds maturing in the near term. This concern is applicable to both investment grade and sub-investment grade markets but given the shorter maturity profile of high yield debt, refinancing risk is arguably far greater in this segment of the corporate bond market. Corporate bond spreads are also at a multi-year low.

Private credit, which has become a darling of the institutional landscape offers the advantages of high floating coupons, flexible structures, and a low correlation (in theory) with traditional fixed income investments, but the cost of these positive characteristics is liquidity. It is undeniable that in a crisis, the limited liquidity in this market would quickly disappear and I suspect any diversification benefits would also evaporate.

There is a plethora of reasons why investors might be increasing their allocation to corporate credit at this stage in the cycle. However, one must assume that the basis for each decision is to improve the investor’s portfolio in some way, perhaps the objective is simply to increase yield or performance.

Uncertainty regarding the path of interest rates has diminished, but investors should not be complacent about the risks still prevalent in the bond market today. As such, we believe that any increased exposure to riskier assets should be accompanied by greater downside protection – in the same way a motorsport team may install a roll cage or bigger brakes when turbo charging an engine. 

Introducing a relative value strategy can provide that protection, by providing investors with an alternative to the traditional drivers of fixed income risk and performance, namely duration and credit.

Virtually all fixed income strategies are dominated by their exposure to duration and credit – the original two levers of fixed income investing. However, pure relative value strategies offer an entirely different risk profile that is not dominated by bets on the direction of interest rates or credit spreads and with the potential to provide truly uncorrelated investment returns.

Perhaps one of the biggest shocks for investors in recent years has been the high correlation between government bonds and equities – historically considered to be excellent diversifiers of each other.  Relative value strategies are typically uncorrelated with both fixed income and equities, providing investors an asset class with true diversification benefits.  For investors focussed on fixed income, relative value provides an alternative source of risk and return – a third lever.