Brian Carney is a portfolio manager with Mawer Investment Management
Embedded in any fixed income investment is the assumption of two types of risk: interest rate risk and credit risk. Interest rate risk is the change in security value caused by a shift in underlying bond yields. Credit risk is the change in security value caused by a shift in the market’s perception of a company’s ability to meet its obligations. Investors who downplay or ignore either of these two risks do so at their own peril as evidenced over the past few years.
Central banks’ adoption of inflation-targeting policies was a contributing factor to decades of falling interest rates from the highs of the late 1980s. Falling rates were a boon for fixed income investors over that period. In addition to the general long-term decline in interest rates, the Credit Crisis and pandemic led to a prolonged period of exceptionally low overnight interest rates, which left many investors convinced rates would stay low forever. If you weren’t long, you were generally wrong—in other words, taking on interest rate risk, intentionally or otherwise, was largely rewarded for decades. This lulled many investors into a false sense of security, leading many to fail to seriously consider the possibility that rates would move materially higher and leaving them unprepared for the bond market carnage to come.
In the U.S., the Federal Reserve’s interest rate normalization policy propelled overnight rates from 0.25% to 5.50% between March 2022 and August 2023. Government bond yields followed suit. After posting 4.4% annual returns between 1997 and 2021, the ICE BofA Global Broad Market Index fell 5.2% in 2021 and 16.9% in 2022. Had it not been for a late rally to end 2023, returns would have been negative for an unprecedented three straight years. After years of complacency, interest rate risk took a serious bite out of the value of investors’ fixed income portfolios.
Financial cycles follow a recurring pattern. A crisis obliges a policy rescue, the rescue provides stability, stability underpins a recovery, and the recovery allows for policy normalization. Once reached, the policy normalization phase continues until the next crisis arrives. When this cycle framework is applied to credit markets, we see a similar pattern of growing complacency amongst market participants. In the case of the credit markets, this has been caused by the unprecedented accommodative monetary policy and fiscal stimulus post pandemic which have combined to support the credit quality of the majority of corporate bond issuers.
While these monetary and fiscal measures did support corporate bond issuers during the depths of the pandemic, investors today remain myopically focused on such central bank policies to the exclusion of other risks that are building in the financial system. For example, any one of the Ukraine or Middle East conflicts, Chinese financial market wobbles, rising corporate insolvencies, U.S. Presidential election, or looming climate disaster have the potential, individually, to upset the current state of calm in the market.
It is often said that credit markets react first with equity markets slow to follow. However, recent history suggests the opposite and highlights the growing complacency in credit markets. Last week, Archer Daniels Midland (ADM) placed its CFO on administrative leave, delayed the release of financial results, and launched an investigation into accounting practices in its nutrition segment. ADM stock fell 24% the day of the announcement. In stark contrast, spreads on ADM’s bond maturing in 2051 were virtually unchanged. Furthermore, Moody’s and S&P took almost two days to react, placing ADM’s A2 / A ratings under review for possible downgrade. Fitch’s A rating with a stable outlook remains. The indifferent attitude of the credit market to a very serious event highlights the disconnect between credit risk and bond valuations.
Speaking of valuations, despite being in the late stage of the economic and credit cycles, credit spreads (the compensation for assuming credit risk embedded in yield) in U.S. investment grade and high yield bonds are well below historic averages. Interestingly though, spreads of Canadian investment grade corporates sit over 30 basis points higher than the historic average. What this suggests is that there are pockets of value to be found in global credit markets, but investors must be selective in where they allocate credit risk today.
Much like fixed income investors were unprepared for an aggressive pivot in central bank interest rate policy, many credit investors today are equally unprepared for the next credit crisis. It is difficult to predict what may precipitate the next crisis. An issuer level event, rising aggregate default levels, or an aggressive new issuer calendar could all be potential catalysts. What we can say with greater certainty is the market can go from being complacent to panicked in minutes and investors often focus on fighting the last battle. Predicting the ‘when’ or the ‘what’ that triggers the next crisis is a somewhat futile exercise. It is better to prepare than predict. Managing credit risk in today’s market backdrop will be as important as managing duration risk was over the last three years.
Today’s investors are faced with the same challenges as they were with falling interest rates, a disconnect between growing risks and rich valuations. We suggest investors rethink their credit exposure, being more selective and dynamic with where they take risk because the playbook of the previous stage of the cycle is unlikely to be what works over the next phase.