The Case for Credit Markets
The Case for Credit Markets
A focus on the income attributes of credit instruments over their capital preservation attributes could make sense for investors in 2025.
The post-pandemic experience can be broadly summarized in one phrase: “Interest rate risk.” This one factor explains much of the performance of a variety of asset classes in the world of fixed income. Credit categories that have exhibited higher degrees of interest rate sensitivity have underperformed; instruments that have commanded lower interest rate risk and higher income levels have done relatively better. This is not a short-term phenomenon, but one that has continued post-pandemic, regardless of prevailing narratives in the market that have oscillated between “lower for longer,” “higher for longer,” “growth scare” and “overheating.” The uncertainty of the macro environment has been consistently overcome by the certainty of income.
It is widely known that fixed income, generally speaking, serves a dual role in a client’s portfolio: income generation and capital preservation. In this era of “higher rates for longer,” we believe it makes a lot of sense for investors to focus on the income attributes of credit instruments over their capital preservation attributes. Thanks to central banks, especially the U.S. Federal Reserve (Fed), lifting from near-zero interest rates and hitting a Fed funds rate of 5.5% at its peak, the structural case for income generation potential is better post-pandemic than it was in the prior decade. We are in a new paradigm, where investors are finally getting paid to take credit risk in their portfolios. These factors have been with us for the past three years and we expect it will likely continue next year.
U.S. Fixed Income Index Returns
| Fixed Income Category |
03/23-2020 | 2021 | 2022 | 2023 | YTD-2024 | Compound Annual Growth Rate |
|---|---|---|---|---|---|---|
| S&P U.S. Treasury Bond Current 10-Year Index |
-0.5% | -3.6% | -16.3% | +3.2% | -0.0% | -3.2% |
| Bloomberg US Corporate Total Return Index Value Unhedged USD |
+22.0% | -1.0% | -15.8% | +8.5% | +2.3% | +2.7% |
| JP Morgan Emerging Markets Bond Index |
+22.9% | -1.6% | -15.3% | +9.1% | +5.6% | +4.4% |
| Bloomberg US Corporate High Yield Total Return Index Value Unhedged USD |
+33.5% | +5.3% | -11.2% | +13.5% | +7.5% | +9.5% |
| The Credit Suisse Leveraged Loan Index |
+28.1% | +5.4% | -1.1% | +13.0% | +7.5% | +11.1% |
Notwithstanding the current easing from central banks, we believe it is unlikely that rates go back to or approach near-zero this cycle. This bodes well for income as a dominant source of returns for fixed income investors on a more secular basis.
Combined with the income attributes of this asset class, there are technical considerations that could continue to favour corporate credit over conventional government bonds. Corporate balance sheets are fundamentally healthy, the economy continues to benefit from relatively supportive fiscal and monetary policy, and financial conditions remain benign. Another supportive technical factor has been the rise of private credit markets, which have been slowly taking share from public markets. The result: moderated growth in the available stock of debt. In other words, supply of public credit continues to be outweighed by demand as the private markets take marginal issuers from our markets. This is potentially bullish for public credit markets.
We hold a particularly optimistic view on the high-yield and syndicated bank loan markets. The significant repricing of coupons post-pandemic has enhanced the income component of their total return profiles, especially for asset classes with relatively low duration. This means investors could enjoy substantial upside potential without sacrificing much on the downside. Additionally, lower interest rate volatility suggests a smoother ride for bond investors, with reduced return volatility.
The relatively inflationary economic outlook favours commodities and, by extension, asset classes such as high yield. Moreover, with corporate balance sheets flush with cash, companies are continuing to deleverage, reducing their need for external financing to cover expenses such as capital expenditures and buybacks. In this higher interest rate environment, companies have demonstrated greater discipline in their debt financing practices.
While our outlook on the asset class is generally bullish, we are highly attuned to the risks that 2025 may bring along. We are specially focused on the fiscal uncertainty injected into global credit markets following the U.S. election. If that leads to a repricing of interest rate risk higher, it could dampen credit returns, especially in markets such as investment grade credit. Furthermore, a second wave of inflation, if realized, has the potential to impact certain cyclically sensitive segments of the credit market.
Andy Kochar is a principal member of AGF Investments’ Fixed Income Team and serves as the firm’s head of global credit. Using a cross-asset framework, Andy is responsible for the research and allocation of credit risk across all of AGF’s fixed income portfolios.
He previously served as Associate Portfolio Manager for AGF Investments' credit-oriented portfolios from 2013 to 2018. Prior to that, for more than five years, Andy served as Investment Analyst, Credit Research at Acuity Investment Management, which was acquired by AGF Management Limited in 2011.
Andy earned a B.A. in Economics (Cum Laude) from York University and he is a CFA® charterholder.
The views expressed are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
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