Divergence & Dispersion

Global Sub-IG in September & October

Key points

  • September and October saw global sub-investment grade asset class total return performance diverge, with US and European high yield bond indices underperforming senior secured loan indices. While rising risk-free rates are the dominant explanation, index-level credit spreads also diverged: European high yield bonds experienced credit spread widening and high yield bonds globally moved within a much wider range than senior secured loans.
  • The key question is why? We attribute the majority of this divergence to technical supply-demand factors specific to individual asset classes: While heavy new issuance is a common supply-side factor across global sub-IG asset classes this year, robust CLO formation has provided a vital source of demand for loans specifically, allowing the asset class to continue performing well in this environment.
  • Recent divergence also highlights long-term structural features that reduce the relative volatility profile of loans versus high yield bonds:
  • Loans are floating-rate, high yield bonds are fixed-rate. It is natural to expect high yield to underperform in an environment of rising risk-free rates and higher risk-free rate volatility, for example, in today’s uncertainty around the path of monetary policy.
  • The dominant investor category in sub-IG loans is the CLO vehicle. CLOs are long-term investment vehicles that, once created, have no exposure to short term capital flows or investor sentiment. This provides a stable, consistent demand base for the asset class. High yield, in contrast, is more heavily exposed to volatile mutual fund flows and, increasingly, ETF flows. In addition, European loans are not eligible for UCITS, ruling out retail investor participation and dampening volatility arising from investor flows. This all manifests in high yield exhibiting higher total return volatility.
  • The recent underperformance in European high yield was accompanied by rising name-level dispersion within the asset class. This created a richer environment for bottom-up credit selection, in our view.
  • Multi-credit strategies are designed to exploit these episodes, both through reallocation across asset classes (as valuations diverge for technical reasons) and reallocation within asset classes (as greater name-level dispersion creates opportunities to add value through credit selection).
  • Our multi-credit funds have been underweight high yield versus loans and CLO debt. We remain so. This preference reflects higher spreads, better downside protection via seniority and security, a more defensive sector profile, and higher private equity participation at a time when private equity has record amounts of dry powder. However, we took advantage of this recent divergence to selectively increase exposure to European high yield bonds, exploiting the shift in relative value.