In fixed income, and particularly non-investment grade credit, one area to consider as a differentiation point between managers (whether active or passive) is in the use and management of stressed and distressed credit. Rather than use credit ratings, which can be stale and backward-looking, we use a market-based definition that flags positions based on their price, spread over government bonds, and yield-to-worst to define and analyze our exposure to these situations. Our portfolio management team evaluates the definition often to attempt to capture the 7-11% of the market in normal market conditions with the highest potential for either total return or default. We refer to this segment of the market as Extended Credit, and then identify securities that share a parent or are otherwise connected to Extended Credit issues, and classify these as Extended Credit-Related names. These definitions allow us to stratify the market into three segments, and evaluate the risk-reward of each investment idea relative to other candidates with similar potential risk and return. We actively manage the allocation to each of the market segments to drive incremental return when our analysis suggests appropriate compensation for the risk.
This type of data also allows for comparisons across time periods to draw conclusions around market drivers. For example, the narrative published in some financial publications has suggested that the strong performance in high yield so far in 2017 has been driven by a “risk on” rally mostly affecting stressed (Extended Credit) names. This narrative may lead to a conclusion that the market’s “tail” is less significant or meaningful to the broader high yield space. Our data suggests otherwise; with no change in underlying criteria, it is interesting to note that the percentage of the Barclays 2% Index that screens as stressed or distressed is unchanged from the beginning of the year, or even slightly higher-weighted if one includes related credits. It is important to note that while the overall percentages of each segment have not significantly changed, the underlying constituents certainly have. As marginal issuers either improve or become further challenged, credit selection becomes even more critical.
The data above also highlights just how important the riskiest “tail” of the market is to the total yield and spread of the high yield market today. Without the contribution of Extended Credit and Extended Credit-Related names, a high-yield investor three weeks ago would have been purchasing exposure to the market at a 4.7% yield-to-worst and an OAS of 309, quite different than the 5.4% and 383 OAS of the index on the same day. Regardless of one’s level of familiarity with the data above and its significance, the key takeaway is that managing the stressed and distressed segments of the market in a disciplined manner from both a credit allocation and selection standpoint is likely to be a key differentiator in terms of relative performance for fixed income funds.
A couple weeks ago my fellow Global Liquidity colleagues Kyongsoo Noh and Ben Ford wrote a blog piece on the state of the short-term fixed income markets (Money in Motion – June 2017). Kyongsoo and Ben concluded “With so much front end cash in motion, what strategies will you choose”? Most investors think of money market funds (MMFs) and short duration when it comes to cash and extended cash investing in the short end. The ultrashort category is less known and represents an attractive alternative for clients. Ultrashort has become an extremely popular category, particularly in the active management segment in recent years. Ultrashort assets in mutual funds and ETFs alone have nearly tripled from USD 35.2B as of December 31, 2010 to USD 102.6B as of March 31, 2017 (Exhibit 1). The amount of cash in ultrashort separately managed accounts has also grown significantly. So what is ultrashort?
Morningstar defines ultrashort as portfolios that invest primarily in investment grade U.S. fixed income issues and have durations typically less than one year. That is a broad description that includes active and passive strategies, investment grade (IG) and high yield bonds, fixed and floating bonds, structured and non-structured investments, government and non-government investments, and many combinations in between. This broad universe includes a great deal of room for interpretation and risk. An active strategy consisting of diversified asset classes such as investment grade fixed and floating-rate corporate and structured debt will provide a different experience from a passive strategy focused solely on floating rate corporate bonds. A higher yielding strategy with elevated levels of credit risk will likely have a much different volatility profile than a lower yielding strategy that invests solely in government securities. A higher duration strategy theoretically would be more sensitive to rates rising than a lower duration strategy. Given the wide variety of styles and investment options in this space, making an ultrashort decision is a difficult one.
Many investors and asset managers alike view the ultrashort category as the first step out from cash given the duration parameters. With the Fed expected to raise rates one more time this year and three times next year, ultrashort is also an attractive solution for investors coming down the curve to protect against rising rates. When selecting an asset manager, understand that not all ultrashort strategies are created equal. As with any investment choice, make sure to select an investment manager with an established, successful platform and a deep bench of talent.
Source: Morningstar. Data as of June 30, 2016.