Credit markets have reached a critical mass in the U.S., with $14 trillion of assets now outstanding compared to the $18.8 trillion in total capitalization of U.S. public equity markets.
The rationale for pension plans incorporating a holistic allocation to credit is derived from its hybrid nature as an asset that offers exposure to the risk drivers of both rates and equities. The differentiated behavior this creates allows credit to act as a tool for diversification — providing lower overall volatility and resulting in a more efficient portfolio with a higher Sharpe ratio. In addition to sharing some risk characteristics with other asset classes, credit offers exposure to diverse return streams and varied structural features, thereby providing a range of risk-reward profiles.
In particular, two distinct developments have occurred since 2008. Structured credit has joined high-yield and emerging market debt as an intermediate risk asset, sharing similar diversification and favorable intermediate return characteristics. These characteristics are accretive to a more efficient portfolio and these assets should thus be included as permanent allocation candidates. Moreover, while there is a reluctance to allocate to credit because of a perceived price asymmetry (with more price downside vs. upside), we argue the total return profile of credit is more symmetric with an upward bias, taking into account the contribution of coupon.
Credit market segments also are not homogenous in terms of risk and volatility. At one end of the spectrum, agency bonds behave as a close proxy to Treasuries while some higher risk corporate credit experiences volatility at levels that are multiples of the Standard & Poor’s 500 stock index. Credit has transitioned from being a rate-like instrument to a high dispersion instrument with the higher-risk segments increasingly behaving as a low-beta equity proxy. This change occurred for corporate bonds gradually over the past two decades and more rapidly for structured products since 2008. Risk over the last two economic cycles, as measured by the volatility of asset returns, has been stable for rates but increasing for credit and equities. For equities this increase was a dramatic 61%, and for high yield assets, 40%.
Overall, the average returns of credit assets since 2008 have had a 0.5 correlation with equity returns and a -0.1 correlation with the returns of rate instruments. While looking at these aggregate figures suggests all credit instruments are functions of the same economic forces, a closer examination proves this is not the case. For example, corporate bond performance is a function of corporate default rates and industrial production, while the performance of non-agency residential mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities is a function of financing cost, unemployment and real estate prices. Thus returns in credit reflect the different economic sectors to which the underlying assets are tied. These diverse drivers mean credit instruments experience very distinct behaviors under the same economic and market scenarios, including significant leads and lags in issuance volumes and delinquency rates.
Over the past two economic cycles, corporate credit has tended to recover earlier in the cycle and to peak midcycle, while non-agency RMBS and CMBS tend to lag the recovery in corporate credit and benefit from falling unemployment and rising real estate prices, a mid- to late-cycle phenomenon. Since credit markets incorporate fixed- and floating-rate instruments, a dynamic portfolio can use various interest rate scenarios to gain exposure to early and late-cycle economic developments or defensive segments during times of economic stress. Within the corporate credit market, different segments, including BB and distressed, have significantly differentiated behavior and dispersion characteristics. Similarly, within structured products, CMBS and non-agency RMBS have different drivers, and supply and demand characteristics.
A closer look at the correlations between the returns of the different credit market segments and other major asset classes provides evidence of their distinct behaviors. The returns of investment-grade corporate bonds are correlated with Treasuries, 0.5, and slightly less correlated with equities, 0.4. High-yield bonds behave differently, with a 0.7 correlation with the S&P and -0.3 correlation with Treasuries, while agency bond returns are highly correlated with Treasuries, 0.77, and subprime bond returns more correlated with equities, 0.52.
Credit assets thus offer a diverse range of risk-reward profiles. Lower risk and volatility segments offer a “money good” profile with lower return dispersion than higher risk/volatility segments. Higher-risk sectors, including CCC and subprime non-agency RMBS, are the most economically sensitive, with rates of return and losses that are functions of default rates, which, in turn, vary with economic activity and market conditions. This economic sensitivity was illustrated over the last few cycles. From 1986 to 1999, higher default and impairment rates caused CCC returns to lag BB returns by 460 basis points annually. Since 2000, CCC assets, benefiting from lower default rates within the high-yield market, achieved returns closer to those of BB-rated high-yield assets, lagging only by 170 basis points.
More recently, the housing sector played the role of the first-loss, most junior economic sector, experiencing a significant correction during the Great Recession, and resulting in significant asset impairment and lower returns for subprime mortgage-backed assets.
While economic events can be significant causes of falling prices, credit market corrections associated with economic recessions also depend on assumed default rates at issuance, which are reflected in the coupon. The returns of economically sensitive segments of the credit markets are highly dependent on current market conditions as they relate to historical default rates, capital market conditions and liquidity in the financial markets. Economically sensitive sectors should be viewed as having a higher dispersion of return outcomes while lower-risk segments should be seen as having a lower dispersion.
Treasuries, agencies and the upper end of investment-grade credit have 3% to 5% return volatilities and a less than 5% maximum draw down, with a comparable return profile. At the opposite end of the risk spectrum, CCC, distressed and subprime bonds can have return volatilities comparable to (or even greater than) equities, with the expected associated maximum drawdown level and return profile.
Serving as a hybrid asset, credit has exposure to both rates and equity risk factors and economic upside, yet it also retains bond features such as coupon, maturity and default sensitivity. While some of these characteristics are counter-intuitive, they are simply the expected results from a complex and mature credit market whose performance is dependent on a number of diverse drivers that deliver a much more dynamic range of outcomes.
Sam DeRosa-Farag is senior strategist at Marinus Capital Advisors, Darien, Conn.
