Chart displaying the tendency of the Bloomberg U.S. Corporate Index to generate negative excess returns when spreads start at levels below 100 basis points (bps). As of 12/31/2024, the index option-adjusted spread (OAS) was 80 bps.
Our approach to fixed income investing is rooted in the observation that bond valuations can be much more volatile or persist at higher levels than underlying credit fundamentals would imply. Implicit in that observation is that both the constant assessment of credit risks and the prevailing pricing of credit risk are imperative to driving long-term returns. Our observations also dictate that there are times when the potential excess returns to credit instruments are quite weak. We sit at that time today.
Credit spreads – a metric that captures the amount of potential income that a credit investment offers vs. a risk-free bond – sit at historically low levels, not experienced since before the 2008 global financial crisis. For index-based investors, forward-looking return prospects are unattractive. The following chart shows how average spread compensation at today’s levels has historically led to near-term underperformance of corporate index bonds against Treasuries.
What is an active credit manager to do in such an environment? Here, we lay out the implications this low credit spread environment has on the pillars of our investment process and portfolios and discuss how it aligns with income and safety priorities.
Implications of unattractive valuations
There are many reasons that a bond manager may hold credit instruments during environments when credit risk is priced unattractively. Bond managers may have performance objectives or incentives to maximize yields, or investors may embrace the notion that historical credit risks are unlikely to occur due to strong macroeconomic data. We believe that:
- Bond-level dynamics are critical to evaluate, necessitating a bottom-up approach.
- We do not need to know exactly what will cause credit spreads to reprice, but something will.
This environment is not new to us. We applied our process through multiple similar episodes of unattractive valuations for credit, including periods in late 2019 and late 2021. In those environments, we did not anticipate that a pandemic, a war between Russia and Ukraine, and a significant Federal Reserve tightening cycle, respectively, would cause credit to become more attractively valued. Rather, our bond-by-bond investment process naturally positioned us to more actively participate when an abundance of durable and attractively valued credits became available.
You might wonder what we do when faced with such expensive environments. Our fixed income team remains disciplined in our investment approach and lets the following elements of our process take center stage.
The virtues of bottom-up investing are evident in all environments and are difficult to understate. This tenet fosters a narrow focus on valuation and durability – sustainable long-term performance drivers for each credit.
Instead of trying to make top-down decisions based on generalizations about industries or the macroeconomy, we focus instead on whether each opportunity meets our valuation criteria and continues to offer the required level of durability. If the investment does, we will either buy it or continue to hold. If the investment does not, we will sell it and continue seeking opportunities. We believe the discipline of executing our process in that manner is the “secret sauce” of our process.
We spend our time looking for the next great value in all markets, but in today’s valuation environment, we find less to act upon. This is a feature of our investment process, not a bug.
At today's low level of spreads, our opportunity set has compressed, but we can still reliably find value in issues in many market segments that are either smaller, esoteric, or unrepresented in mainstream indices. The inclusion in our evaluation process of non-index credits across a variety of sectors is unique among fixed income managers, in our experience.
Looking beyond benchmark credits can uncover opportunities that still offer attractive valuations because of noneconomic reasons, such as investor preferences, rigid guidelines, liquidity concerns, or perhaps a misunderstanding of the actual underlying credit risks. These opportunities still offer strong durability features but lack the size, issuance frequency, number of assigned credit ratings, or structures that investors prefer. This willingness to look beyond benchmarks helps us identify durable credits at attractive yields, which continues to drive long-term, sustainable performance benefits.
Everything described so far may seem straightforward. In reality, it can be difficult to ignore the lure of some additional short-term return for otherwise durable credits when we deem them to have inadequate valuations. Our long-term focus requires embracing the uncertainty of when valuations will cheapen. We know that, on average, credit instruments will offer higher income over the long term, but we don’t know what will cause valuations to change, nor when it will occur.
A strong valuation discipline provides a “north star” to navigate decisions in these environments. It allows us to be comfortable in saying “no” – a lot – when evaluating credits for potential purchase. This creates a culture where our analysts do not need to fear the consequences of inaction because they are investing according to a disciplined process, evaluating the broad opportunity set, and aligning credit investments with clients’ long-term objectives in mind.
A strong valuation discipline provides a ‘north star’ to navigate decisions in these environments.
This same discipline applies to our continued focus on sound portfolio construction. During these expensive periods in credit markets, constant vigilance of portfolio exposures is maintained to limit any unintended risks or concentrations that can overwhelm potential benefits from our bottom-up credit selection. This includes:
- Limiting the risk of interest rate movement vs. the strategy’s objectives
- Ensuring proper diversification
- Modeling risk factors
- Maintaining similar exposures across client portfolios
Portfolio impact
Applying our bottom-up, bond-by-bond investment process over the past few months resulted in measured changes to client portfolios due to both cash flows within the portfolios and our purchase, sale, and hold decisions. In general, portfolios have de-risked organically as bonds matured, we sold credits that reached our “sell” criteria, and attractive values diminished.
This can be observed in some of the following ways:
- The market weight of “reserves” or high-quality, liquid, noncredit investments such as U.S. Treasuries, futures, or cash has increased. These reserves are a source of available funds to purchase credits when appropriate valuations re-emerge.
- The market weight of credit investments decreased in a corresponding manner.
- The credit portion of portfolios has become less sensitive to future credit spread changes.
Alignment with client objectives
Clients have many potential long-term objectives for their fixed income portfolios, including capital preservation, income generation, diversification of risks, liquidity, and downside protection. We are confident that a bottom-up investment process, executed properly, aligns with these objectives.
However, these long-term objectives can present conflicts when viewed through a short-term lens. For example, the desire to generate income can conflict with preservation of capital when credit valuations are expensive, as they are today. We believe that our portfolios are positioned to preserve capital through an episode when valuations are repriced to reflect the historical risks present in credit investments.
Conversely, when valuations become widely attractive, which tends to happen after a risk event, there comes a time to actively seize opportunities in the market and pursue objectives of income generation. Our steadfast focus on credit valuation and durability helps ensure that income potential is attained without sacrificing objectives of safety and preserving capital over the long term.
Today’s credit markets are expensive. There is broad uncertainty about what risk event or interest rate movement will unfold next. Fortunately, our investment process does not require precise predictions about the timing or magnitude of events for portfolios to perform well and align with client objectives. As in past situations with similar credit conditions and sentiments, we do not know what future event(s) will rattle markets – nor do we need to know. We know something will occur to reset credit spreads, and it is best to be prepared to respond.
[O]ur investment process does not require precise predictions about the timing or magnitude of events for portfolios to perform well and align with client objectives.
Conclusion
Our disciplined investment process of buying strong credits at appropriate valuations will not change. We believe our client portfolios are well positioned to navigate this period of narrow credit spreads. We are not avoiding risk; rather, we are approaching credit risk both cautiously and constructively. This process has worked in the past, and we believe at this point in the credit cycle that patience and discipline will be rewarded over the relatively small amount of extra income that can be attained.
If you are interested in learning more about our approach to credit investing, reach out to a member of the Fixed Income team or your BBH relationship team.
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Opinions, forecasts, and discussions about investment strategies are as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.
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