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.