Decision Time: Equity or Credit?

Decision Time: Equity or Credit?

With the future uncertain and concern about drawdown risk elevated, credit's defensive characteristics are increasingly important to allocation decisions.


Lately, clients have been asking which asset class offers the best return prospects over the next 12-18 months: equity or credit? This is a fair question. We’ve seen a decent recovery across most market segments since the depths of March. Equity and credit markets, in particular, appear to have much more room to run, especially when compared to year-end 2019 levels (Exhibit 1). But, while we’ve seen steep declines in some asset classes, this is not a typical financial crisis. We’re in the midst of a devastating public health crisis that has deeply affected governments, corporations and households worldwide, with the road to recovery still uncertain.


Exhibit 1: Where Do We Go From Here?

Source: Bloomberg. As of 15 May 20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

We recognize the powerful allure of buying equity at these levels given its historical record for outperforming credit following major selloffs. However, we don’t believe this is the time to make investment decisions based on a belief that we’re headed back to a pre-COVID-19 way of life. That view simply underestimates the gravity of the time we’re living in and what the world may look like a year from now.

Bear in mind that the latest equity market correction was not only deep, but it was also the fastest on record. That speed dynamic, combined with an equally record-breaking response by policymakers, is what quickly turned market “fear” into “greed” and ultimately sparked the sharp rebound in the days that followed. While the rally across equity and some segments of the credit market put investor sentiment back on more stable footing, we believe the rebound was primarily stimulus-driven. Now the hard part begins as some countries and states in the US look to ease lockdown restrictions and as we await more progress toward the development of a vaccine.

Per our 2Q20 Global Outlook, we expect a steeper economic downturn than we saw during the early quarters of the 2008 global financial crisis (GFC), with signs of a modest recovery taking hold in the second half of 2020. However, there are still risks to this forecast. For example, further mutations of the virus could make it harder to defeat. Furthermore, should business reopenings stall or move backward, or should the crisis deepen or extend further into 2021, the potential for permanent damage to consumer and corporate balance sheets increases.

There’s also the possibility of experiencing multiple “false dawns” or dead cat bounces—measured as the maximum rise from a low point that was later breached once again—on the road to recovery. As highlighted in Exhibit 2, in most periods when the market fell by at least 25% there were rebounds of at least 10% on several occasions along the way to the bottom.
 

Exhibit 2: The Road to Recovery Is Strewn With Potholes

Percentages reflect the maximum rise from a low point, which was ultimately breached once again at a later stage.

Source: Samuel H. Williamson, 'Daily Closing Value of the Dow Jones Average, 1885 to Present,' Measuring Worth, 2020, and Schroders. As of 01 Apr 20.

Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

With this backdrop in mind, portfolio diversification is essential. Plenty of total return opportunities currently abound, but the range of future economic outcomes is wide. Therefore, protecting portfolios against drawdown risk should be the main focus. And here we would advocate maintaining an allocation to credit in any broad investment portfolio for its more defensive characteristics and ability to play a meaningful role in generating steadier, long-term total returns.

Granted, coupon levels on corporate credit have drifted lower over the past years on the back of sustained central bank policy accommodation. However, government bonds continue to offer low to negative yields. And the impact of the COVID-19 crisis on revenues and earnings is now forcing many companies to drastically cut their equity dividends to stockpile cash and fortify balance sheets. With equity challenged not just by the fundamental outlook, but also by technical headwinds (e.g., less buyback activity), we see credit markets—specifically corporate credit (in US dollars, euros and sterling), bank loans and structured credit—as offering investors the potential for compelling returns given today’s elevated spreads and our expectation for a low-interest-rate environment for the foreseeable future.

Exhibit 3 features a table of post-GFC performance results across various asset classes, which underscores the ability of credit to keep pace with (and in some cases exceed) equity market recoveries.
 

Exhibit 3: Post-GFC Performance Across Asset Classes

Source: Morningstar, Bank of America/Merrill Lynch (BAML). As of 01 May 20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

We have no doubt that the news flow over the next 12-18 months will be choppy; incoming global economic data, ongoing US-China trade discussions, the path of oil prices and the upcoming US presidential election—all of these will dust up periods of market volatility. As noted in our 2Q20 Global Credit Monitor, we will likely see more ratings downgrades, fallen angels and defaults across credit markets, especially in stressed sectors such as energy and retail. But with credit spreads near historical highs, we see a prime opportunity to exploit sector and issuer-level price dislocations and build up our exposures in those issuers that can endure and rebound sharply as spreads begin to normalize. History has shown that whenever credit markets unhinge, the period that follows has the potential to offer investors outsized returns for the taking just as long as investors are able and willing to strike while the window is open.


Definitions:

COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARS­CoV-2.

The Great Recession, also known as the financial crisis of 2007–08, the Great Financial Crisis (GFC), global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.

A dead cat bounce is a temporary recovery from a prolonged decline or bear market, followed by the continuation of the downtrend.

Coupon is the periodic interest payment made to the bondholders during the life of the bond.

Structured credit investments include collateralized bond obligations (CBOs), collateralized debt obligations (CDOs), syndicated loans and synthetic financial instruments.  A CBO is understood to be of investment grade, but is backed with the use of a pool of below-investment-grade bonds. CDOs are a kind of asset-backed security, holding a pool of collateralized debt, such as mortgages and auto loans, that may be subdivided into various tranches representing different levels of risk.  A syndicated loan is a loan offered by a group of lenders (called a syndicate) who work together to provide funds for a single borrower. Synthetic financial instruments are artificially created investment vehicles or instruments intended to meet requirements not met by existing, conventional instruments. They are designed to reduce risk, increase diversification or offer a higher return. A synthetic floating rate instrument can be produced by combining a fixed-rate bond and an interest rate swap. Or an asset with the same risks and rewards as the underlying share can be created by the purchase of a call option and the simultaneous sale of a put option on the same share.

A fallen angel is a bond that was rated investment-grade but has since been downgraded to junk status due to the declining financial position of its issuer. The bond is downgraded by one or more of the big three rating services.

A yield spread or credit spread is the difference in yield between two different types of fixed income securities with similar maturities.

One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).

A false dawn is a promising situation which comes to nothing. In investing, a false dawn is an upward move or short trend which fails to continue.

Symbol/Abbreviation

Index/Definition

Exhibit 1

 

EURUSD

Euro currency per U.S. dollars

JPYUSD

Japanese yen per U.S. dollar

EM FX Index Level (JPM)

The JP Morgan Emerging Market Currency Index (EMCI) is a tradeable benchmark for emerging market currencies versus US dollar.

SPX Index

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

WTI Crude ($/bbl)

West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing; bbl is an abbreviation for “barrel”.

Henry Hub Gas ($/mcf)

Henry Hub is a natural gas pipeline located in Erath, Louisiana, that serves as the official delivery location for futures contracts on the New York Mercantile Exchange (NYMEX); $/mcf is an abbreviation for “dollars per million cubic feet.”

US IG or HY Spreads

The difference in yield between US Investment-grade (IG) or high yield (HY) bonds and the equivalent risk-free rate

Exhibit 3

 

Russell 2000

The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

S&P 500

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

MSCI EM

The MSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

MSCI EAFE

The MSCI EAFE Index is an unmanaged index of equity securities from developed countries in Western Europe, the Far East, and Australasia.

Global Agg (ex-US)

The Bloomberg Barclays Global Aggregate Bond Index is an unmanaged index of global investment-grade fixed-income securities.

US Agg

The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. The index includes institutionally traded U.S. Treasury, government sponsored, mortgage and corporate securities.

IG Credit

The Bloomberg Barclays U.S. Corporate Investment Grade Index is an unmanaged index consisting of publicly issued US Corporate and specified foreign debentures and secured notes that are rated investment grade (Baa3/BBB- or higher) by at least two ratings agencies, have at least one year to final maturity and have at least $250 million par amount outstanding. To qualify, bonds must be SEC-registered.

HY Credit

The Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade debt, including corporate and non-corporate sectors. Pay-in-kind (PIK) bonds, Eurobonds, and debt issues from countries designated as emerging markets are excluded, but Canadian and global bonds (SEC registered) of issuers in non-emerging market countries are included. Original issue zero coupon bonds, step-up coupon structures, and 144-As are also included.

Bank Loans, MBS, UST

Bank of America Merrill Lynch (BAML) indexes covering bank loans, Mortgage-backed securities, and U.S. Treasuries, respective

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