The investment opportunity is compelling, but there are important factors to consider
Investors are hearing more about credit as an effective investment, as it outperforms traditional fixed income. The word credit has many definitions, and in this context it refers to the opportunity to lend money for a fee or a return. Making a loan is a type of credit investment, as is being the lender for a mortgage, while buying a corporate bond is the most common credit investment.
Individuals typically borrow money through a loan, a line of credit, a credit card, or a mortgage, while governments and companies borrow money through the bond market by “issuing” a bond. The investors who buy the bond are the lenders. The investors lend their money for a certain amount of time for a fee, and that fee is called the yield or the coupon on the bond. The yield and the coupon are usually the same when the bond is issued, but the yield of the bond changes over time while the coupon stays static.
The yield of a bond changes over time because the bond’s coupon is made up of two main elements – an interest rate and a credit spread – and each of those elements can fluctuate. The interest rate portion of the bond’s yield is determined by the yield of a similar tenor federal government bond. Government bonds are considered risk-free, so they don’t require an additional credit spread. For non-government borrowers, an additional credit spread that reflects the credit quality of the borrower is added to the government bond yield to determine the total yield, or the coupon. The credit spread reflects the likelihood that the borrower will make the timely payments promised by the terms of the bond. Lower-quality borrowers have higher credit spreads, and therefore pay a higher yield or coupon to borrow.
The fact that investors are hearing more about credit investing lately is likely due to three main themes. The first is that investors, including institutional, are searching for better investments, potentially looking to decrease interest rate or equity exposure. The second is the refreshed opportunity to buy a private debt or a mortgage fund and benefit from being the lender at these compelling higher yields. This has developed because of the rapid rise in interest rates and is exacerbated by the proliferation of non-bank lenders as bank lending retrenches. Many of these non-bank lenders manage funds that facilitate exposure to a diversified portfolio of loans or mortgages. The third reason that credit investing is a compelling theme for investors is because certain funds that isolate exposure to the aforementioned credit spreads have delivered exceptional returns while the rapid rise in interest rates has decimated many individual bond and bond fund returns.
I said that a bond was made up of an interest rate and a credit spread – so how did investors benefit from investing in credit spreads without being decimated by the rise in interest rates? Good question. Certain bond funds, which have existed for more than a decade, are set up to invest in the credit spread portion of the corporate bond only, and they eliminate most or all the interest rate risk. In fact, some of these credit funds have outperformed the flagship iShares Core Canadian Universe Bond Index ETF by more than 10 percent in the past year with a similar or better risk profile, where 10 percent is exceptional outperformance in fixed-income investing.
An important differentiation for credit investing is that the investment is based upon a borrower’s promise to pay, within a time frame, and the fact that that promise takes precedent over most or all the borrower’s other obligations. That promise may also be further secured by an asset. Unlike the price of a common share, a bond is simply an annual payment and then the repayment of your money on a pre-determined maturity date. If the company doesn’t make those payments, then actions commence to curtail their business and protect the lenders. While the price of that bond does fluctuate between issuance and maturity dates, it is much less reliant upon either company earnings or growth to perform as expected. This point has become particularly salient as we face an uncertain economic outlook and investors search for more safety in the portfolio. Astute investors are evaluating both the absolute returns and the risk-versus-return proposition of credit versus rates, and indeed credit versus fixed income or equity investments.
Private credit may well offer a more compelling expected return for lower risk than the merits of private equity for the next while. Good private debt funds have returned more than 10 percent in the past year, while the future looks bright due to higher rates and more lending opportunities. Thorough due diligence for existing private holdings is essential after the tumultuous last few years.
The debate rages on about where interest rates will go from here. We have seen capitulation recently by many debt and equity investors who were expecting a rapid return to lower rates, and growing support for the higher-rates-for-longer narrative. Inflation continues to be one of the market’s major themes and will likely determine the next interest rate moves and the shape of the interest rate curve. These higher rates, and indeed higher loan, corporate bond, and mortgage rates have created compelling investment opportunities for those who thought that equities were the only way to meet return targets. TINA has gone from There-Is-No-Alternative to There-Is-aN-Alternative.
My aim is not to forecast where interest rates will go from here. However, these refreshed levels make bonds much more compelling and important developments within fixed-income investing have created the opportunity to invest separately in interest rates and credit spreads. It’s an important development because rates and credit move distinctly and for different reasons at different times. You can now choose funds that offer exposure to rates or credit or both, depending on your view. Notably, for many of the same reasons that rates and credit spreads move differently, the skill sets required for managers to manage each one are also distinct, where rates and credit portfolio management each require their own expertise with specific tools and strategies. Consider choosing an interest rate expert for rates and a credit expert for credit, because the data shows that they are rarely the same person or fund.
The current and forward-looking opportunity in credit investing is compelling, even after strong outperformance during a few challenging years. However, the timing, credit-quality focus, manager selection, the quality of the mortgages and private debt already held in funds, and your outlook are extremely important factors when choosing your investment. Depending on your portfolio requirements and your outlook, this might not be the time for high-yield debt, or for loans to certain sectors of the economy or to certain borrowers. Your investment choice today might wisely be to prioritize a proven, lower-risk credit fund. You may need additional information about signs of delinquency in the portfolio and consider their current valuations for non-public and therefore less-visible assets.
A portfolio of high-quality mortgages, the right private debt manager, and short-term investment-grade credit look like compelling current credit investments. Some mortgages will carry CMHC insurance or other guarantees that further support the credit quality. Some private credit funds have an excellent track record for thorough underwriting due diligence, which should help to allay current valuation fears, and their recently higher return expectations should buffer potential credit degradation. Short-term investment-grade credit spreads are already cheap on a historical basis, pricing in most of a recession, which provides protection for potential future economic weakness. The current yield that some of these investment-grade credit funds are generating, without exposure to volatile interest rates, provides inherent protection. It creates a supportive break-even level, where credit spreads could move materially higher before the portfolio stops generating a positive return, a risk-reducing trait that most bond and stock funds cannot offer.
Other notable aspects of credit investing include its ability to diversify a portfolio, with distinct drivers and low correlation to rates and equities. The absolute and risk-adjusted returns of credit funds typically improve total portfolio risk metrics. Credit usually has lower price volatility, but note that some credit investments are not priced daily, which can artificially lower their volatility. Down capture, Sharpe ratio, and max drawdown stats also distinguish the better credit managers. With those benefits, and the compelling recent and expected returns, it might be time to consider how the right credit investments bolster your portfolio.
Kevin Foley is a managing director, institutional clients at YTM Capital. YTM Capital is a Canadian asset manager focused on “better fixed-income solutions,” specializing in credit and mortgage funds. Kevin is the former head of credit trading and fixed income syndication at a major Canadian bank. He sits on three Canadian foundation boards and investment committees.
