Credit exposure should be smart and short in 2022
As we mentioned in our
, rates volatility and a tightening of financial conditions will be two of the major headwinds faced by markets in 2022.
The news headlines may be distracted by the omicron variant currently, but away from COVID related volatility we expect central bank policy to continue to be a key driver of returns. What makes this particularly tricky for bond investors (though admittedly this is nothing new), is that we don’t need to see policymakers actually do anything for markets to swing quite considerably; witness the significant volatility in rates markets we have experienced already in 2021, a year largely devoid of concrete policy changes from the major central banks.
Thus, as they look ahead to 2022, investors will likely be questioning the degree of conviction they have on a number of issues; when might the Fed accelerate tapering? When might it lift off on rates? When and how will its ‘dot plots’ change? Will the Bank of England deliver its much-anticipated December hike? Will it stick to its communicated 50bp/1% rates thresholds for halting Gilt reinvestment and then selling down its holdings? How will the ECB recalibrate its purchases between the PEPP and the APP?
We know that one way to avoid unwanted volatility from yield curve adjustments is to have interest rate duration close to zero. So it is little surprise that floating rate bonds have been mentioned more than once in investment banks’ recommendations for 2022 in recent weeks. Goldman Sachs, for example, noted that rising inflation in the US “could end up being much better for consumers than for companies”, so investors should be “rotating out of corporate bonds and into asset-backed securities and other securitized debt,” while Morgan Stanley strategists said they “prefer securitized to corporate credit.”
Floating rate bonds can give investors upside in a rising rate environment as their coupons are reset higher in line with base rate rises. This makes them a very popular choice during a tightening cycle, and they often see significant inflows during these periods. Floating rate investments can actually be found in most parts of the fixed income markets; investment grade corporates, financials, covered bonds, leveraged loans and European ABS, for example.
However, an important consideration for investors is how they replace the yield they lose by removing their exposure to the government yield curve. So where can they find value in the floating rate world?
We typically look at this on a credit spread basis – in other words, what is the margin over the risk-free rate? – and it is pretty slim pickings in some places. Floating rate corporates and financials with a AAA rating only offer you 5bp and 1bp, respectively, though by the time you get down to BBB that has grown to 35bps and 50bps. OK, but not exactly enticing. Covered bonds look a little better, with around 16bp of spread on AAA bonds and 117bp at the BBB level.
Dipping below investment grade, leveraged loans are typically BB and B rated, so you should, and do, get a material pick up for the excess credit risk you are taking. Leveraged loans currently offer around 360bp at BB and 460bp at B, with the benefit of a Euribor floor effectively worth another 31bp on a three-year loan. These should prove very popular while default rates are so low and rates uncertainty so high.
European ABS currently offers the highest spreads of the lot for comparable ratings. There are a range of AAA opportunities from Prime RMBS at 27bp through to non-bank RMBS at around 75bp and CLOs at 95bp, while at the BBB level we see non-bank RMBS at 180bp or more, CLOs at 330bp and CMBS at around 300bp.
Again dipping below investment grade we would look specifically at CLOs (portfolios of leveraged loans), where we currently see BB CLOs at around 650bp and B CLOs at 950bp (CLOs also benefit from the same Euribor floor as their underlying leveraged loans). Consequently, we think ABS and CLOs represent the best opportunity within floating rate bonds in 2022, with returns driven by carry alone likely to outpace almost every other part of fixed income in our view.
Clearly there are a number of options for investors to step away from central bank policy risk, and more than enough credit spread out there to replace the yield received from the rates curves.