Within the investment grade corporate bond market, investors are seeking additional yield over treasury and agency bonds—other part of their core fixed income allocation—but within a margin of safety. So the investment grade corporate bond space, for instance, is supposed to have a much lower default risk than, say, the high yield bond space.
That’s the justification for investing in that space, but obviously there are many risks still involved. One is interest rate risk, or duration risk, which is the sensitivity of investment grade bonds to changes in interest rates. There’s liquidity risk, which is simply the costs of buying and selling securities, or the risk of not being able to sell when you need to. Third key risk, of course, is credit risk, which, although this is the investment grade space, the best way to define credit risk really is the risk of default. But think of that over long periods of time. That default risk over shorter to medium term periods may translate into downgrade risk. And that’s one way to really measure the risk of price changes—price gain or loss in investment grade bonds.
One approach to finding value that I think is particularly strong is by isolating credit risk and selecting attractive bonds—so, through credit selection. And how can you do that? You can start by neutralizing some of the other risks. So, liquidity risk, focus on the more liquid part of the investment grade universe. It’s a very, very large universe, can eliminate some of the smaller issues, non-public companies, etc., and end up with a more liquid part of the investment grade universe. You can break the universe up into duration buckets, so you can do an apples-to-apples type of comparison of yields and spread within those duration buckets in order to try to identify bonds that may actually be attractive from a how credit risk is priced perspective.
The major step here, then, is finding an effective valuation technique to price credit risk, which is measured in terms of spread over Treasuries or option adjusted spread for, say, callable securities. The idea there is to come up with a theoretical spread and compare that with market spreads and then identify value. A bond whose market spread trades at a premium, or is higher than its theoretical spread is an attractive bond.
What’s really interesting about this is that basically the pricing of credit risk, or this theoretical spread, all comes back again to default risk. It’s interesting to always talk about default risk in investment grade bonds, but as I explained earlier, over shorter periods of time, that really translates into the probability of a downgrade occurring for an investment grade borrower.
We have a couple of strategies, one in the broad investment grade space, MIG, one in the BBB space, MBBB, that uses a rich data set from Moody’s Analytics, which is really decades of data on defaults and recoveries. But also involves a very quantitatively driven approach to screen what is an incredibly large universe. The Moody’s Analytics data set also incorporates equity market data, which is really interesting in the context of a credit model, because equity market data obviously is refreshed daily, and you can avoid, particularly when it comes to valuing the assets of a company, it avoids the stale data that a lot of credit models tend to use.
We’re in a prolonged, low interest rate environment, and it’s, I think, very useful for investors to have strategies, whereas, opposed to merely adding to risk to enhance yield, you could seek more yield for some time of measurable unit of risk. And what the MIG and MBBB strategies do are use these models to try to find attractively valued bonds based on some measurable level of credit risk and find bonds whose spreads are more than adequate compensation for that level of credit risk.
Why do that today? You know, the opportunity is there. The investment grade market now in the U.S. has a market value of about $8.4 trillion, which is about $5 trillion higher than it was 10 years ago. And, so the growth has been tremendous, which might indicate, there could be more opportunities to find rich bonds and cheap bonds. But also, risks in the investment grade have increased in a couple of ways. Duration is about two units longer than it was 10 years ago. And overall credit quality is lower in terms of the ratings mix is more geared toward BBB. And, by the way, you’re receiving about a 150 basis points or so less in terms of overall yield than you were a decade ago for investment grade bonds. So, investors have to find ways to find yield, but rather than just increasing duration risk or increasing liquidity risk, or simply increasing credit risk, these strategies offer an opportunity to seek, as I mentioned earlier, a greater yield for a measurable unit of risk—in this case, credit risk.
Using these types of investment grade strategies within a portfolio, a broad IG approach, sort of the MIG approach, really could be part of a core fixed income allocation. It tends to be similar duration to the broad investment grade universe, but, as I mentioned, adding a screen for attractively priced bonds based on their spread versus their theoretical spread.
Also, by the way, I should mention that the screen, by seeking bonds with more than enough compensation for their risk of downgrade also screens out bonds that don’t have enough compensation for their risk of downgrade. And within the investment grade space, that’s obviously very important. But it’s particularly important within the BBB space. For investors who have sought more yield within the credit space in general, gone heavier in BBB, or looked for crossover strategies, by using an approach like this, one may be able to avoid some degree of fallen angel risk. Fallen angels, bonds who’re downgraded from investment grade to high yield, from BBB to BB. They suffer the greatest price losses usually upon heading into downgrades. And the strategy that can help screen out some of those fallen angels may be very useful within the BBB universe. On top of that, you’re still seeking the more attractively valued bonds within the BBB space. So, that all-BBB strategy we have could be part of a broader crossover strategy, part of a core strategy where you are adding credit risk overall, relative to the broad investment grade universe, but trying to make up for that with higher spread compensation and avoiding some degree of fallen angel risk.
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