The Case for Front-End Credit

The Case for Front-End Credit

Current market conditions make the shorter end of the maturity curve potentially attractive from a risk/reward point of view.

Fixed-income investors face a variety of questions; among them perhaps none is more important than the question of risk and reward. How much am I being compensated for the amount of risk that I am taking? How does that compare to all of the other opportunities out there? Given current market dynamics, short-term credit stands out as one of the more attractive opportunities today.

Since late 2015, the Fed has raised front-end interest rates by a total of 225 bps or 2.25%. This has caused short-term corporate bond yields to rise. At the same time, intermediate and longer-term corporate yields have stayed in almost exactly the same place. What this does is provide investors with a decent amount of yield without forcing them to take duration risk or longer-dated credit risk.

Consider these numbers: Historically speaking, investors have been able to pick up an additional 300-400 bps of yield by extending further out the maturity curve, a relatively decent amount of compensation for the risk. However, that number has shrunk to just 140 bps of additional spread compensation for extending as much as 30 years. Not only do investors have the added duration risk of a longer-dated bond (could be as much as 16 years' worth), but there is also the added risk of investing in a corporate bond out to that long maturity date. The longer the maturity, the less transparent the business will be—another factor that makes front-end credit the more compelling place to be.

A question about short-term credit that we get asked often is "why now?" There are a few reasons but none bigger than the unprecedented dovish pivot by the Fed this year. At the end of December, it seemed as if the Fed would continue on its hiking path for the next couple of years. However, here we are just six months later and the Fed has made its first interest rate cut in a decade, a stunning dynamic for market participants to digest. This will create more demand for the front end of the yield curve and ultimately drive these yields lower. We think this opportunity will not be around for long.
 

Exhibit 1: Front-End Yields

Over the past seven years, front end yields have risen by 200 bps while 10-year yields are exactly the same.
Chart: Fed Funds Rate v. 10 Year Yields

Source: Bloomberg. As of 12 Aug 2019.  Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Of course, while all of this has been occurring in the US, the rest of the world has seen interest rates march lower and lower, in many cases into negative territory, such that there is now over $15 trillion dollars' worth of negative-yielding fixed-income assets (or 30% of total fixed-income around the globe), another remarkable development for investors to grapple with. The search for yield is becoming a global crisis.

So for investors who are considering credit but want to avoid duration risk, or for investors who want exposure to credit but are perhaps concerned with recession risk, we believe front-end credit offers a very attractive risk/reward opportunity. There are a variety of investment vehicles to gain exposure to this, many of which may offer a generous coupon without requiring the investor to take additional duration and credit risk-- and could potentially be excellent diversification tools for investor portfolios.


The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

One basis point (bps) equals one one-hundredth of one percentage point.

The yield curve, or  maturity curve, shows the relationship between yields and maturity dates for a similar class of bonds.

The federal funds rate (Fed Funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the Federal Reserve for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.

Duration measures the sensitivity of price (the value of principal) of a fixed-income investment to a change in interest rates. The higher the duration, the more sensitive a fixed-income investment will be to interest rate changes.

 

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.