Making credit assets work harder to deliver returns in this incredibly low-yielding environment has been a challenge for institutional investors. Pensions are increasingly turning to investment managers who can look across the credit spectrum — from investment-grade to high-yield to emerging-markets debt to loans — for the best opportunities.
Taking a money lender mind-set, for credit investors it’s about finding worthy companies — that is, borrowers — and buying their debt at the most attractive prices available to generate strong risk-adjusted returns. In practice, for us at J.P. Morgan Asset Management, right now that means a preference for quality high-yield bonds over those from more highly levered companies. In view of current and forward-looking fundamentals, European high-yield more than compensates investors for credit risk when we look at prices relative to the expected level of losses or the average default rate. In other words, the risk premium for buying high-yield bonds issued by certain companies is compelling, particularly in Europe. Even after a strong rally this year, high-yield is looking to be a good value relative to large swaths of the government bond market now yielding in negative territory as a function of central bank rate cutting. The ongoing support of the European Central Bank also functions as a strong technical tailwind, supporting prices of bonds issued by investment-grade companies, particularly in the banking sector, where there has been ongoing deleveraging, which is also supportive of bondholders.
Indeed, as the ECB further expands into selective corporate bond purchasing, there’s increasingly a place in multisector credit portfolios for some lower-yielding investment-grade credit assets. We recommend this strategy in part because the ECB will be physically buying investment-grade bonds and in part because the negative deposit rates the ECB and the Bank of Japan have implemented are causing more investors to turn from shorter-dated investments and reach for yield. In fact, the ECB is expected to buy up something like half of the net new nonfinancial issuance across the European market from June onward. So although all-in yields on investment-grade credit are lower than on high-yield bonds, the capital appreciation prospects and risk-adjusted yields still make the asset class a compelling investment over the medium term.
At the moment, our most meaningful overweight allocations are to sectors in which we see the greatest transparency on cash flows. Within high-yield credit, that might be communications or technology companies providing yield and spread sufficient for the probability of any loss. We strive not to overextend in the riskier credits, even within a high-yield allocation. As a result, our portfolio reflects a more defensive tilt, with a preference for issuers with a stable cash flow profile, such as health care and cable and other utility companies.
Squeezing better risk-adjusted returns from credit is also about considering the role that hedging strategies like derivatives can play. This effective portfolio insurance gives managers the ability to capture upside potential while still having protection from losses when the markets are overvalued. As for some of the broad trends affecting debt markets, greater regulation has meant that investment banks have reduced their footprints across capital markets. In practice, this outcome means they lower corporate bond inventory and have less ability to act as a buffer to market volatility. As such, we view the ability to implement strategies intended to dampen the impact of rising volatility via liquid derivatives as a core part of a multisector credit portfolio.
Lisa Coleman is head of global investment-grade credit at J.P. Morgan Asset Management in London and New York.
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