Janus Capital's Gibson Smith on why corporate credit now plays a critical role in generating superior risk-adjusted outperformance.
The Janus fixed income team has long held the view corporate credit matters in fixed income. In mid-2009, we observed the recent dislocation in the fixed income market would transform the way investors and asset managers approach fixed income investing, and predicted corporate credit would likely play a critical role in generating superior risk-adjusted outperformance. At the centre of our thesis was the convergence of agency mortgages or mortgage-backed securities (MBS), government agencies and US Treasury sectors of the fixed income market into one large government sector, leaving corporate credit as essentially the lone non-government alternative (see chart below).
Driving the transformation in the fixed income market was the unprecedented government intervention, particularly in the mortgage and agency markets. The seminal event occurred in September 2008 when the US Government placed Fannie Mae and Freddie Mac into a conservatorship. From that point, spreads of agencies and agency mortgages relative to US Treasuries began to narrow and the returns for these segments remained highly correlated.
Meanwhile, the correlation between corporate credit and these government-related segments dropped significantly. We viewed these dynamics as evidence of the structural change that was underway in the fixed income market and projected these changes would likely result in corporate credit playing a larger role in the pursuit of outperformance within fixed income. We saw this unfold in 2009 and we believe these dynamics will continue into 2010.
2009: a quick recap
Passive index strategies, which are heavily weighted to government or government related bonds, significantly underperformed most active fixed income managers in 2009. Spreads of agency mortgages tightened to just 18 basis points (bps) over US Treasuries have tightened further, as have high yield corporate spreads by year-end. Meanwhile, spreads for corporate credit (investment grade and high yield) tightened drastically, placing credit among the top-performing fixed income segments in 2009. Correlations between credit and the government-related sectors remained at relatively low levels.
Despite the strong relative and absolute performance of corporate credit in 2009, we maintain our view that exposure to corporate credit will likely be the most important factor in generating risk-adjusted outperformance in fixed income. Those seeking investments with yields greater than government bonds have few alternatives given low-yielding US Treasuries and the tight spreads of agency mortgages and agencies. Additionally, a number of fundamental and technical issues are still working against the “new” government sector of the fixed income market.
Why credit will continue to matter in 2010
Supply and demand factors: Continued stimulus combined with lower tax revenues has led to greater borrowing needs for the US Government. In 2008 and 2009, the US Government’s net issuance of US Treasury notes and bonds totaled more than $2.6trn; this is up considerably from earlier in the decade and represents a record amount of US government debt. The likelihood of even greater issuance in 2010 could place upward pressure on interest rates in the US over the near term.
Meanwhile, corporate America continues to pay down its debt. This massive deleveraging trend is likely to continue as corporations attempt to clean up their balance sheets— suggesting there will be downward pressure on the supply of corporate credit, which could provide for further spread tightening in this segment as investors’ demand for higher yields helps to drive prices up. In short, we think the supply/demand dynamics for both government securities and corporate credit favours the latter.
Relative price volatility: Since US Treasuries offer lower coupon payments than other types of fixed income investments, these securities typically provide little income cushion in the event interest rates rise, resulting in increased duration or a greater sensitivity to interest rate movements. As a new government sector, agency mortgages also offer low coupons and little spread over US Treasuries, subjecting them to a similar level of price volatility as interest rates fluctuate. With return potential basically equivalent to that of US Treasuries, the upside in agency mortgages seems limited, while the downside could be significant, particularly in a rising interest rate environment. On the other hand, corporate credit’s higher coupons are more appealing while higher spreads between corporate credit and US Treasuries provide a better cushion in the event interest rates do rise. Given the poor technical and fundamental characteristics of agencies and agency mortgages, we think corporate credit will continue to be more attractive than the new government sector.
Government support of mortgage market: In late December, the US Treasury essentially gave Fannie Mae and Freddie Mac unlimited access to US Government assistance through 2012.
Nearly all new mortgages issued during 2009 were backed by Fannie and Freddie. We think this support is likely to remain for an extended period of time and will likely leave the yields on agencies at levels close to US Treasuries.
Meanwhile, the Fed has continued to purchase agency mortgages in an attempt to help stabilise the housing market. Because of the Government’s intervention and the Fed’s purchases, mortgage rates have remained relatively low and we have seen some evidence the housing market has begun to stabilise. We think without the Fed’s purchase programme, there will be upward pressure on mortgage rates and agency mortgage spreads, which will in turn drive down MBS prices. While the US Government’s continued support of Fannie and Freddie may help mitigate upward pressure on rates, private demand for agency mortgages is likely to remain low. We think this dynamic makes agency mortgages a difficult place for fixed income managers to attempt to generate alpha.
What does this mean for investors?
With few spread alternatives other than corporate credit, fixed income managers who employ a top-down sector allocation approach in the new paradigm are left with a difficult task. Further, given the relatively low spreads on agency mortgages and agencies, the risk of making a wrong call on interest rates is very high. Instead, we believe fixed income managers will gravitate more toward corporate credit in an attempt to generate superior risk-adjusted performance.
However, risk management and security selection is critical, and managers with experience in corporate credit will likely have an advantage over those who have to alter their approach given the changed landscape.
Gibson Smith is co-chief investment officer and co-portfolio manager of the high-yield, balanced and flexible bond disciplines at Janus Capital
