01 The importance of credit

Investors can’t afford to ignore credit, especially European investors. 

We find that a balanced mix of euro investment grade credit and euro high yield credit would have outperformed an equally balanced allocation split between German government bonds and European equities over the period since a European high yield index was first launched in 2001. What’s more, the credit portfolio’s return and risk profile has been better in both rising and falling interest rate environments.

Overall, credit offers better Sharpe ratios – the balance between risk and return – than the more traditional asset classes. So, for instance, euro investment grade credit has offered better returns at lower volatility than German government bonds – the standard “risk-free” instrument. And high yield credit has generated considerably better returns for substantially lower risk than European equities. At the same time, investment grade and high yield credit have had substantially lower maximum drawdowns than German government bonds and European equities respectively (see Fig. 1), while corporate failure is more catastrophic to equity investors than to corporate bond holders. 

This result remains the same whether central banks are raising interest rates or cutting them (see Figs. 3 and 4). Setting the 10-year German sovereign rate as the reference rate, the properties of the two portfolios have been computed during the years when the interest rate has been increasing (10 years out of 23) and during the years when the interest rate has been decreasing (13 years out of 23). In both environments, the credit portfolio exhibits superior returns with lower volatility, and therefore a better Sharpe ratio, in comparison to the mix of government debt and equities.

The average annual default for investment grade issues – those rated BB or higher – is negligible. Default risk only becomes relevant for credits rated B and only becomes significant for those rated CCC and below. But at the same time, the premium investors receive for bearing credit risk rises rapidly the lower the credit rating. In fact, credit spreads more than compensate investors across the rating spectrum, since the average annual excess return, including loss on defaults, remains positive for all credit ratings.

To put this into perspective, it’s important to remember that when companies go bankrupt, their equity is often wiped out. For example, between 1980 and 2019 more than 400 companies were removed from the S&P 500 because after not recovering from distressed levels. This corresponds to an annual average of 2 per cent of companies in the index. By contrast, the average annual default rate for European high yield issues is 1.3 per cent of index face value since 2001. What’s more, when companies go bust, the value of their equity goes to zero, leaving investors with little. By contrast, investors have, on average, seen a recovery rate of 40 per cent on high yield credits in default over the past 20 years. Nor does this consider that active investment teams can help companies avoid default.

At the same time, the credit quality of European high yield issuers has improved noticeably over the last two decades, rising two notches from B2 to BB3. This is significant: the estimated historical average probability of default of the BB3 rating category is 0.37 per cent, well below B2’s 0.94 per cent. In other words, investors in European high yield credit are less exposed to default risk than in the past. 

05 Shock absorbing

Credit pays an income and its price steadily converges to its face value as the bond approaches maturity.

As a result, market shocks that cause the bonds to drop in value are time limited – once the shock passes, credit tends to stage a strong recovery. By contrast, equity losses can persist after serious market dislocations. That’s because credit offers contractual returns, unlike equities. 

Historically, recovery in European high yield is always well under way within six months of a market drawdown of at least 10 per cent and occasionally has posted a full recovery. And in all cases losses have been erased by 18 months following the market drop. Similar results also follow less severe drawdowns. By contrast, European equities have tended to have much slower and less complete recoveries after severe drawdowns.

Trying to time the market makes little sense – few can do so accurately – and missing entry points represents huge opportunity costs. 

Strategic allocation and patience reward the long-term investor in credit: the pull-to-par drives the bond price higher, and the carry is realised. Chasing optimal exit and entry points in credit – in other words, trying to time the market – can come with a considerable opportunity cost, especially since credit recoveries tend to be swifter than that for equities.

And that’s without taking into account the additional benefits that credit offers. Such as that companies tend to issue new bonds at a discount, giving those early investors a built-in return. Or the liquidity premium attached to small bond issues. Or the fact that investors can improve the return their credit portfolio generates by allocating along the yield curve – longer dated bonds tend to generate higher yields. Or that credit often comes with optionality, a complexity that can lead to mispricing and therefore investment opportunities for those who have the tools to analyse the bonds.

06 What matters to credit

Credit markets are most sensitive to shocks in refinancing costs, which, in turn, are primarily determined by shifts in monetary and fiscal policy. Monetary policy is driven by a combination of real growth, inflation and excess leverage risk, with the latter two the biggest factors in changes to the risk-free rate and hence refinancing risk. By contrast, real growth rates tend to move within a narrow range and never shift suddenly.

Over the past fifty years, credit has steadily delivered stronger returns than government debt, across most growth and inflation regimes. Low growth environments have tended to be very favourable to credit, to the detriment of equities. On the other hand, while credit suffers during periods of high inflation, so to do equities. 

“Investors who patiently apply longer investment horizons to credit allocation are rewarded.”

Credit is no more a hybrid asset class than are equities. And timing the credit market is much less relevant than it is to equity investors, where missing an entry point can make a very substantial difference to returns. Instead, investors who patiently apply longer investment horizons to credit allocation are rewarded. 

Finally, the credit asset class offers additional opportunities beyond collecting the yield, that investors can harvest. We have designed our investment process with these all of these factors in mind to maximise the prospect of generating positive and steady excess returns over the long run.