Return of the MAC: A dynamic approach to credit investing

June 19, 2024

With fears of an economic hard landing abating and rates expected to stay higher for longer, our co-head of public markets and portfolio manager Mike McEachern discusses how a greater allocation to high yield, underpinned by strong risk management, can potentially boost the return appeal of a multi-asset credit strategy.

Recent years have presented challenges for credit asset classes due the fastest interest rate-hiking cycle in four decades², as central banks tried to keep a lid on the inflationary pressures that built up during the pandemic and tried to control the spike in commodity prices resulting from the Russia-Ukraine conflict. Investors seeking yield no longer needed to reach down the risk spectrum. Government bonds and money market funds suddenly offered yield. 

Today, and despite fears to the contrary, a significant economic slowdown has failed to materialise. In fact, hopes of a ‘soft landing’ have given way to the possibility of a ‘no landing’ scenario in the US and other countries, as the growth outlook remains the base case. In its latest World Economic Outlook, published on April 16, the International Monetary Fund upgraded its global growth forecast for 2024 by 0.1% to 3.2%, with US growth upgraded by 0.6% to 2.7%

Strong economic output and sticky inflation have put a pause on US rate cuts for now and, even when they do materialise, the expectation is that rates will remain higher for longer. Meanwhile, a softer, but still improving, macroeconomic picture in Europe could result in mid-year rate cuts. 

While higher rates are good for cash and government bonds, there are also significant opportunities for credit investors to benefit from the spread premium. And, even when spreads are tight, we believe investors can access attractive yields, especially in high-yield (HY) bonds, without having to veer into the CCC or even lower quality parts of the market where all but one of the 37 credit defaults recorded in Q1 2024 took place³.

The benefits of a multi-asset approach to credit

Investing in one credit sub-asset class can have its advantages, but it comes with a higher concentration of risk. A multi-asset credit (MAC) approach can diversify that risk while increasing yield and total return potential, through combining different credit sub-asset classes.

More conservative investors may prefer a MAC portfolio with a greater weighting to investment grade (IG) bonds given their relative safety and security in a variety of market conditions. Yields in this segment tend to be lower than their HY counterparts. However, IG bonds can offer slow and steady income generation via the coupon as well as the potential for low-mid-single digit returns (depending on the market and rates environment), alongside capital preservation.

Risk: Diversification does not assure a profit or protect against loss.

Those with a modestly greater risk appetite may wish to allocate more to high yield, especially against the backdrop of a strong and improving macroeconomic environment. As previously mentioned, the high yield global investment universe of c.US$2 trillion¹ across developed and emerging markets offers a wealth of opportunities for investors able to identify credits with strong underlying fundamentals and an attractive yield premium.

A well-structured MAC strategy can properly deal with the recent increase in bond prices. Importantly, it will have the ability to invest during market dislocations and/or sell-offs which can provide greater return potential through a longer holding period, as we believe the best market opportunities tend to be during shorter periods of indiscriminate selling, not just when markets are going up.  

One should always keep in mind that one of HY’s key features is its regular coupon income. Compounding this income and incorporating it into the price return provides an attractive total return picture over the longer term, as Figure 1 illustrates.

Risk on

HY bonds may be more volatile than their IG counterparts given their greater economic sensitivity. A greater tolerance for volatility is required if investors want the additional yield.

This is where credit selection really comes into play; CCC rated bonds are considered at the riskier end of the spectrum, but the yields are particularly compelling. Yet when picking these low-rated bonds, investors need to be sure of their credit work. In fact, one of the key benefits of taking a longer-term approach to HY means that, over time, the yield can help mitigate the price volatility. 

While rigorous credit analysis is one of the key tools in an asset manager’s arsenal when investing in HY bonds, a broader knowledge and awareness of rising and falling trends across the credit universe is a must. The high yield market comprises different industries that operate within their own “business cycles” e.g. financials, cyclicals and non-cyclicals. While all industries are influenced by the broader macro environment, they can differentiate from each other based on their own specific industry factors. A multisector credit strategy that also focuses on identifying emerging and maturing industry trends may add further advantages to a purely top-down credit allocation strategy. Additional tools, such as the ability to implement hedges to protect a portfolio during periods of instability, can also help insulate a higher-yielding portfolio from unwanted volatility.

Furthermore, investors may consider a complementary allocation to IG bonds alongside HY to diversify their portfolio and help smooth the return profile.

Stronger for longer

Higher base rates offer investors the potential to earn higher yields without needing to move down the risk spectrum. Given the inverse relationship between yields and price, with higher yields come lower average prices – currently c. 93 in the US⁴ and 94 in Europe⁵. At these prices, an investor will receive an additional 7 or 6 points at maturity when the price reverts to 100.

Given the tendency of issuers to refinance before maturity, this discount is recouped over a shorter timeframe, resulting in a significant increase in yield and spread. While this is not a common phenomenon, it is present in today’s market conditions. In this scenario, the more commonly referenced yield-to-worst calculation may underestimate the potential realised return for bond investors reflected in the yield-to-call calculation (Figure 2).   

Abating recessionary fears and a higher-for-longer rates environment, notably in developed markets, gives a green light for HY. The asset class offers a compelling level of yield, with spreads compensating for default risk.

Credit quality is improving – only 10% of the global high yield universe is CCC rated⁶, and the investible universe – certainly in Europe – is shrinking, with a lack of supply underpinning prices ⁷. While defaults are rising, they are likely to be limited given the underlying fundamental strength of HY corporates, especially in the higher-quality BB and B parts of the market. HY bonds also tend to have shorter durations, making them less sensitive to changes in interest rates.

For MAC investors, diversification is already part of the package. Yet those who want more risk and are willing to accept the volatility, could consider strategy with a higher weighting to HY, complemented by a smaller, but still beneficial, allocation to IG.

However, this shouldn’t be a short-term, tactical allocation, but a more strategic, long-term investment that looks to benefit from deep credit analysis, as well as a strong understanding of market dislocations and the broader macroeconomic environment.

References

1.ICE Index Platform, The ICE BofA ML Global High Yield Index (HW00), as of 31st March
2.Statista, ‘The most aggressive tightening cycle in decades, as of December 2023
3.S&P Global Ratings, ‘Default, Transition, and Recovery: Global Defaults Are Still High Despite Dipping In March,’ as of April 16, 2024.
4.ICE Index Platform. ICE BofA US Cash Pay High Yield Index (J0A0), as of 31st March 2024.
5.ICE BofA BB-B European Currency Index Non-Financial High Yield Constrained Index (HP4N), as of 31st March 2024.
6.ICE Index Platform, ICE BofA Global High Yield Constrained Index (HW03), as of 31st March 2024.
7.ICE Index Platform, ICE BofA European High Yield Constrained Index (HEC0), as of March 31st, 2024. The index has shrunk 18% over the last 2 years.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of May 2024 and may change without notice.

---------

Index Descriptions

HW00 - The ICE BofA ML Global High Yield Index tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the major domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of USD 250 million, EUR 250 million, GBP 100 million, or CAD 100 million.

J0A0 - The ICE BofA ML US Cash Pay High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt, currently in a coupon paying period that is publicly issued in the US domestic market.  Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

HP4N – The ICE BofA ML BB-B European Currency Non-Financial High Yield Constrained Index contains all non-financial securities in The ICE BofA ML European Currency High Yield Index rated BB1 through B3, based on an average of Moody's, S&P and Fitch, but caps issuer exposure at 3%.

HW0C – The ICE BofA ML Global High Yield Constrained Index contains all securities in The ICE BofA ML Global High Yield Index (HW00) but caps issuer exposure at 2%.

HEC0 – The ICE BofA ML Euro High Yield Constrained Index contains all securities in the ICE BofA ML Euro High Yield Index (HE00) but caps issuance exposure at 3%.

Important Information

Muzinich and/or Muzinich & Co. referenced herein is defined as Muzinich & Co., Inc. and its affiliates. Muzinich views and opinions.  This material has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Rates of exchange may cause the value of investments to rise or fall. Emerging Markets may be more risky than more developed markets for a variety of reasons, including but not limited to, increased political, social and economic instability; heightened pricing volatility and reduced market liquidity.

Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.

This discussion material contains forward-looking statements, which give current expectations of a fund’s future activities and future performance. Any or all forward-looking statements in this material may turn out to be incorrect. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Although the assumptions underlying the forward-looking statements contained herein are believed to be reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurances that the forward-looking statements included in this discussion material will   prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation that the objectives and plans discussed herein will be achieved. Further, no person undertakes any obligation to revise such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

United States: This material is for Institutional Investor use only – not for retail distribution. Muzinich & Co., Inc. is a registered investment adviser with the Securities and Exchange Commission (SEC). Muzinich & Co., Inc.’s being a Registered Investment Adviser with the SEC in no way shall imply a certain level of skill or training or any authorization or approval by the SEC.

Issued in the European Union by Muzinich & Co. (Ireland) Limited, which is authorized and regulated by the Central Bank of Ireland. Registered in Ireland, Company Registration No. 307511. Registered address: 32 Molesworth Street, Dublin 2, D02 Y512, Ireland. Issued in Switzerland by Muzinich & Co. (Switzerland) AG. Registered in Switzerland No. CHE-389.422.108. Registered address: Tödistrasse 5, 8002 Zurich, Switzerland. Issued in Singapore and Hong Kong by Muzinich & Co. (Singapore) Pte. Limited, which is licensed and regulated by the Monetary Authority of Singapore. Registered in Singapore No. 201624477K. Registered address: 6 Battery Road, #26-05, Singapore, 049909. Issued in all other jurisdictions (excluding the U.S.) by Muzinich & Co. Limited. which is authorized and regulated by the Financial Conduct Authority. Registered in England and Wales No. 3852444. Registered address: 8 Hanover Street, London W1S 1YQ, United Kingdom. 2024-04-30-13490