Finding The Sweet Spot in Global Credit

Finding the Sweet Spot in Global Credit

Speaker names and titles:
Anna Martin
Relationship Manager

Pilar Gomez-Bravo
Co-CIO Fixed Income

Anna Martin: How attractive is investment grade credit in this point in the cycle, particularly relative to the other aspects of fixed income universe?

Pilar Gomez-Bravo: So, I think that investment grade credit is probably the sweet spot of exposure in fixed income. And the reason for that is twofold. One is because obviously the absolute levels of yields are supported by the underlying government bond high yields as monetary policy tighten. So, on top of that you have a nice spread that provides you cushion for your returns.

So, if you still expect some volatility in the underlying moves in rates, then having that extra cushion of spread that investment grade provides you helps buffer that total return, right? So, it gives you a little bit of extra cushion. The break evens are much better, so you need to see widening of 80 basis points before you start having negative total returns. But the other element of investment grade that plays a really interesting role is that it tends to be the most offensive asset class within credit.

Anna Martin: There seems to be a lot of dispersion between the US and European investment grade. Why is European investment grade so compelling at the moment?

Pilar Gomez-Bravo: I mean, I love managing global fixed income and global credit because there’s just so many different ways, so many levers that you can pull. And one of the things that we’ve noticed is obviously that the Euro investment grade credit markets had wind out significantly relative to the US and rightly so. Obviously we have war at our doorstep and obviously there was a significant concern for severe recession in Europe due to the impact of energy prices going higher. However, we have now seen that due to the control of some of the companies in industrials in Europe and the storage of gas and the mild winter, we’re not likely to go into recession and therefore you have a really nice compensation for risk in the European investment grade markets, which are much slower duration. So, you think about the duration in the European investment grade market, it might be around five years, where traditionally the duration in the US investment grade market has been maybe seven years.

So that means that on a risk adjusted basis you have more interesting spreads for similar quality companies and with less duration. So, we’ve been advocating, we’ve been sort of in our portfolios basically positioning ourselves towards more exposure to European investment grade credit because you get that little bit of extra loss adjusted spreads and you can still select the companies that you like. So ultimately whether you want to be invested in European investment grade or US investment grade, I think given the uncertainties that you mentioned earlier today, it is really paramount that you have a strong research platform. So, it’s great to be able to allocate from the top down, but ultimately you need to pick the right names given the uncertainty that we are facing going forward.

Anna Martin: Being picky seems to be the way forward, yes. We talked about recession risks and cost of capital is increasing. We’re seeing falling profit margins. In what shape are corporates to navigate this type of environment? And do you see any sectors more at risk than others in the near term?

Pilar Gomez-Bravo: So, one of the most interesting elements of investing in credit is that you have the bottoms-up security selection lever. But at the same time, you have sort of a top down lever that you can pull. And the most exciting times to be an active manager in global credit is when you have dispersion in sectors and you have volatility. And so that’s what we anticipate and we are starting to see dispersion across the credit markets. And when you’re constructing risk, which is kind of what we do as portfolio managers, you can sort of play with beta and for example in Europe because everything widened, you can sort of basically create more beta from that part of the market. And at the same time the US credit markets offer you a lot of dispersion between sectors.

So that allows you to create a package of risk that really fits that sort of upside return within the bottoms-up ideas from the analyst. I would sort of say as well with regards to the opportunities that we still favor banks both in Europe and in the US. And the reason for that is twofold. One is because there were large suppliers of bonds in the market and therefore their spread’s wide and therefore are pretty cheap relative to the non-financial corporate sector. So, you’re picking up spread.

They tend to be higher quality if you’re going up in cap structure. So, we sort of favor having more exposure to senior debt rather than very deep subordinated debt at this point because of the cycle concerns that we have and therefore your ratings tend to be really higher. So, the banks also are one of the few sectors that actually benefit from rates increasing. So, when you think about building risk in credit, you want to, at this point in time given the inflation concerns and rate dynamics, you want to be avoiding rate sensitive sectors, you want to go into sectors that benefit from rate increases. So, banks, for all those reasons, is one of the sectors that we prefer in our portfolios.

Anna Martin: How do you and the team think about energy supply dynamics and the implications for global credit markets?

Pilar Gomez-Bravo: So, we have two pulling factors in energy markets and particularly obviously oil. The first one is a current paradigm of you have a war in Russia, you have caps and sanctions and you have China reopening at the same time. So that normally would lead to higher oil prices basically, at least in the short term. At the same time in the US, they’re building or rebuilding their storage, so their reserves, and that again sort of draws demand for oil higher. And on top of that, you haven’t had any new exploration because of green concerns around fossil fuels.

So, you could have a crunch in the very near term that leads to oil higher. However, in the longer term usually it’s obviously a market that is driven mostly by global demand and supply considerations. So, if your base case or if you’re expecting a significant slowdown in global growth at some point and potential recession, then longer term you’d have to think that energy pricing comes down. One of the key things that we’re looking forward to is really kind of continuing to engage with the energy companies that we talk to understand their capex plans as they think about this transition in energy policy going forward. And that again will sort of create maybe different options to energy that companies can use beyond just with traditional oil markets.

Anna Martin: For clients that are thinking about making an allocation to global credit, what do you think is the key question that they should be asking their global credit manager to really evaluate their skill?

Pilar Gomez-Bravo: I mean one of the obvious questions is how do they construct a risk in their portfolio and how do they allocate it and how dynamically are they sort of looking at sector opportunities, but also more importantly, what is the strength of the research platform? How can they evidence security selection going into periods of stress? And more importantly, I think one of the key questions that these days asset owners should be asking their credit managers is how do they handle liquidity in their portfolio? Again, we know that it’s an over-the-counter market and therefore when you’re evaluating credit managers, you really need to assess how they think about liquidity in the portfolios and how do they navigate where they get compensated for liquidity risk and where they really want to maintain a more flexible approach to the holdings that they have.

Anna Martin: Over the last two decades, beta was the key driving factor for investors both on the equity and fixed income side. Now that fixed income sectors have re-rated, is the environment more favorable to active managers?

Pilar Gomez-Bravo: Yes, it was. It’s been challenging in a period of negative yields to convince a lot of asset owners that actually active management had a lot of value, so we saw a huge transition to passive. But once the Fed put is no longer there, then you really do need to be able to navigate the different sectors and the different risks that you have in your portfolio because you don’t really have somebody to step in and save you when things go wrong.

And so that changed the fact that the Fed is no longer there because of inflation to provide your put is something that I think the markets haven’t caught onto yet because many, many years of loose monetary policy have created a moral hazard in the markets. And I think for the first time we’re seeing very large institutional clients that are switching their portfolios from passive to active.

Anna Martin: In Australia, as with elsewhere in the world, private credit has generated a lot of interest and investor capital. What is your view and do you think the market is taking into account the risks associated with investing in private credit at the moment?

Pilar Gomez-Bravo: So, I usually have a pretty neutral opinion of most asset classes. I don’t think that there’s an asset class that by nature itself is bad or good. I think there’s just bad and good managers of the asset class. And so, one of the things that you have to consider in the growth of private credit markets, which by the way have funded the growth in private equity markets, is that very long extended periods of loose monetary policy create fragility in financial markets. And that‘s through the credit channel and through the asset price overheating. And private credit growth is at the heart of some of these issues. The challenge is obviously as we look around and identify risks to the credit markets and risks to general fixed income markets or even equity markets, the thing that‘s very difficult to capture is the hidden leverage.

And that‘s where the concerns are. The concerns are that because of the lags in pricing or repricing the books of private credit, that is really difficult to look under the hood overall and sort of understand really where that hidden leverage is. And so, it is an area of concern in general because it could lead to basically a systematic unwind of leverage that would make some of these issues problematic.

So, I would advocate or I would suggest I guess that those asset owners that are deeply involved in private credit that just again manage the allocation risk overall and importantly manage the diversification risk. One last comment is that normally participating in an illiquid product in front of a recession is not necessarily great because you’re locking yourself in a vintage where the underwriting risk maybe is not as strong as it should be. And so that’s the only thing that you would have to think about when you’re looking to allocate now to private credit markets.

And one last point is that there is a growing pool of assets that are being created for secondary private credit opportunities. And to me what that tells me is that they’re expecting significant stress in private credit if you’re creating funds to buy distressed private credit exposure. So normally these markets look ahead and so if you’re creating some of these secondary pools of money to buy stress private credit when it shows up, that means that I think that there’s an expectation that we might have some issues in that market.

Anna Martin: Absolutely. Well, thank you very much for your insights Pilar. That’s been absolutely fascinating. Thank you for tuning in and hope to see you soon.

 

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