For fixed income investors, varying the amount of credit risk in your portfolio can exert a major influence on the portfolio’s realized alpha. Indeed, historical data shows that this single factor can have a larger impact than decisions around what bond sectors or individual issuers to invest in. Accordingly, it’s worth spending some time thinking about precisely how much credit risk to take and when. My latest research in this area focuses on the role that valuation can play in adjusting credit risk over an economic cycle.
Methodology at a glance
I looked at the strategic timing of buying and selling credit exposure (in the form of corporate bonds, using cash or US Treasuries as a funding source) with low turnover, and using market valuation as the sole buy/sell signal. There are, of course, other predictive drivers of credit returns, such as monetary policy, investor sentiment, and market technicals, but I believe valuation to be the most concrete and reliable due to its mean-reverting nature and its direct tie to cash flows.
In addition, I focused on credit spreads and index returns in excess of duration-matched Treasuries, rather than yields and total returns. While spreads have been consistently mean-reverting over a credit cycle, interest rates (yields) have not.
First, I looked at when (at what point in the cycle) and how to “buy” the excess returns of the Bloomberg Barclays US High Yield Corporate Index and found that:
- When credit spreads reached fairly cheap levels during a crisis period (e.g., the COVID-19 pandemic), the most profitable all-weather buying strategy was to wait until spreads reached the 85th percentile versus their history and then add credit exposure very quickly — and that’s important — by taking an overweight position in the index. Even at the risk of some moderate short-term pain, this strategy would have captured 59% of the potential maximum return, on average, over a credit cycle. (Figure 1).
Using the same index, I repeated this exercise for when and how to “sell” credit risk amid tight credit spreads and found that:
- When spreads tightened, the most effective strategy was to wait for really rich spread levels (e.g., 5th percentile versus their history). Then, very slowly — again, that’s important — reduce index exposure to an underweight over a period of many months. However, it may make just as much sense to not short credit risk at all, as the potential rewards for doing so tend to be much smaller than those for properly buying credit. In fact, the best all-weather shorting strategy added virtually no value over remaining neutral relative to the index!
In response to all of this, clients that are constrained from buying high-yield bonds may ask: Do these results still hold up when using investment-grade corporate bonds instead of high yield? The short answer is yes, even if you have no cash or Treasuries to sell. In this case, selling shorter-duration and/or higher-rated bonds and then buying longer-duration and/or lower-rated bonds may be the way to go. For high-yield investors, when spreads widen meaningfully, consider buying as many long-duration high-yield bonds as possible, especially fallen angels.
Figure 1 shows the historical average alpha capture from buying high-yield credit at various spread percentile thresholds (and selling when spreads return to the historical median) and at different buying speeds (small number is faster).
Be realistic and keep it simple
Every credit cycle is different, and it’s unlikely that you (or I) will be able to time the next one perfectly. Instead, the goal should be to maximize the chances that you’ll be able to earn a significant portion of the available alpha in each cycle. To do that, I suggest turning to simple but powerful strategies that are likely to work reasonably well in all types of environments.