Through the 1990s and 2000s, the fixed-income world was divided, for good reason, into two broad categories with low-risk credits (e.g., AAA/AA rated sovereign debt, AAA/AA rated securitized debt, AAA/AA rated corporate debt) on one side and higher-risk credits, such as high-yield and emerging markets debt, on the other. This separation was supported by evidence that correlations across these domains were low and volatility was higher in the newer markets.
Investors generally responded to this situation by giving specific discretionary mandates to their managers as to which categories of debt to invest in, fundamentally separating the asset class exposures.
By the mid-2000s, divisions between credit markets already had begun to blur and the economic crisis, subsequent global recession and wild disruption of the credit markets in 2008-2009 left a dramatically changed landscape.
The vast majority of sovereign credits (by value) are now investment grade. Corporate credits now largely span the single A to single B range. Effectively, both sovereign and corporate credits now cover a much tighter range of credit quality with implications for volatility, correlations, and investment opportunities.
In corporate credit, the trend of convergence in credit quality across high yield and investment grade is also evident, although in this instance it is driven by a deterioration in investment-grade corporate credit quality. The behavioral characteristics of investment-grade credit are increasingly similar to the high-yield market. Along with this, the correlation of the credit component of investment-grade returns with the same element of loan and high-yield returns has risen substantially.
So, consider the change to be two forces pushing toward the middle: as investment-grade credits have diminished and weakened, higher-risk credits have strengthened and expanded.
This is the “new normal” of the mid-2010s: a convergence of credit quality across a wide spectrum of credit sectors leading to a narrowing of volatility differentials across asset classes and increased correlation. We think of the “new normal” in terms of a different market structure for credit. In turn, the diversification and return benefits associated with a portfolio of discrete allocations is likely to be lower while the need to manage allocations to control risk and return will be larger.