Credit Strategies Positioned for a Cyclical Recovery

Brandywine Global examines the outlook for global corporate and structured credit.

    Brian Kloss

    Brian Kloss Brandywine Global

    Tracy Chen

    Tracy ChenBrandywine Global

    Global Credit

    US corporate credit markets continue to benefit from foreign investor demand

    Given expectations for a vaccine and the tremendous policy responses at work, we see a very high likelihood of a cyclical recovery and further spread tightening in corporate credit due to stronger global gross domestic product (GDP) growth. The new adminstration in the U.S. could lead to increased corporate tax rates and regulations, which introduces some uncertainty. However, we believe the extensive monetary and fiscal support, including the potential for another U.S. fiscal stimulus package, would outweigh any economic constraints resulting from these potential regulatory headwinds.

    Therefore, we remain constructive on risk assets, expressing that view through corporate credit markets. A major tailwind for corporate credit markets is the continued strong demand from foreign investors, which has allowed credit markets to issue at record amounts and enabled companies to lower the cost of capital and extend their maturity profiles. Our focus now is on the economic cycle as basic industries, capital goods, energy, and other cyclical sectors in both developed and emerging markets are still trading at spreads wide to historical levels. We favor those industries that have a more cyclical tilt, like autos and mining, which should see marked improvement as the economy rebounds from the lockdowns. As the global recovery progresses, demand resumes, manufacturing and exports tick higher, and the medical front draws nearer to resolving the COVID-19 pandemic, we believe conditions are in place for a reflationary trade and substantial spread tightening in these more cyclical areas of the economy

    Reasons to favor the middle of the credit-quality spectrum

    Our team believes both the BBB and BB quality segments offer the best risk/return profile and should remain supported by monetary policy and the significant excess money supply currently in the system (see Exhibit 1). Also, we favor European high yield, which has more direct involvement from the central bank along with a lower predicted default rate in 2021 versus the U.S. market. We remain optimistic on foreign state-owned oil companies and recent fallen angels that hold some of the most sought-after assets in the U.S. Within the energy sector, we see the potential for continued supply contraction in the U.S. and a more normalized demand profile in 2021. We are troubled by both ends of the credit-quality spectrum, with high quality offering limited total return potential, and lower-quality bonds still susceptible to hiccups in the global economic recovery. However, if the global economy picks up steam, we may anticipate moving farther down the quality spectrum.

    EXHIBIT 1: EXCESS GLOBAL US$ MONEY SUPPLY, 3M ANN, % As of December 04, 2020

    Sources: The MacroStrategy Partnership, Bloomberg L.P.

    Lastly, while inflation is a risk that we continuously assess, we do not envision a significant back-up in yields in the near term. However, we likely favor opportunities that include some of the following charactersitics:

    • a shorter maturity
    • an option-adjusted spread (OAS) that will compensate or cushion an investor for a back-up in the risk-free rate
    • cyclical exposure
    • commodity exposure
    • non-US assets
    • lower-quality assets

    Structured Credit

    New credit cycle favors a “down in credit” trade

    Structured credit price recovery has been mostly lagging that of corporate credit, especially lower in the capital stack. Looking forward, vaccine breakthroughs have reduced the tail risk in structured credit, while accommodative global monetary and fiscal policies should boost the momentum of the economic recovery. With a new credit cycle in place, we think that a “down in credit” trade should provide opportunities, including moving down in the capital stack and investing in senior tranches of lower-quality collaterals or newer off-the-run products.

    • U.S. Housing market
      In 2021, we believe the housing market will remain firm with 3% to 5% appreciation, boosted by a shortage of housing supply, low mortgage rates, demographic trends, including millennials buying, and the structural shift from urban renting to suburban home ownership. Low-to-middle price tier homes should outperform as a result of younger cohort buyers favoring more affordable areas. Household balance sheets are in solid shape with higher savings rates, less leverage, and support from forbearance and stimulus programs.

    • Agency Residential Mortgage-backed Securities (RMBS)
      Fed purchases will continue to provide a supportive backdrop, but higher interest rate volatility and prepayment risks will increase the negative convexity. We would prefer non-agency RMBS as we believe taking credit risk will be more rewarding than taking interest rate risk.

    • Non-Agency RMBS
      We like CRT (credit risk transfer), single-family rental, and re-performing loan/non-performing loan (RPL/NPL) securitizations for exposure to the housing recovery with measured borrower default risk.

    • Asset-backed Securities (ABS)
      We see a shift down in quality across consumer ABS, preferring subprime BBB/BB auto ABS, auto lease ABS, and sectors that were hit hard by COVID, e.g., container lease, timeshare, whole-business securitization, etc.

    • Commercial Mortgage-backed Securities (CMBS)
      We expect commercial real estate (CRE) prices to decline gradually, mostly in retail and hotel sectors. However, this trend should be much less severe than the 35% decline during the Global Financial Crisis (GFC) due to better underwriting, attractive cap rate spreads to Treasuries, and large amounts of private money waiting on the sidelines to buy distressed CRE properties. We expect absolute stress levels in CMBS will remain high in the near term. We favor quality (AAA through A) in conduit CMBS and single-asset/single-borrower CMBS.

    • Collateralized Loan Obligation (CLOs)
      BBB/BB CLOs and middle market CLOs can benefit from an early credit cycle rotation.

    • European RMBS
      Spanish and U.K. residential mortgage-backed securities (RMBS) mezzanine tranches provide value given the European Central Bank's very accommodative stance. However, capital appreciation is key as carry is minimal due to the floating-rate nature of these securities.


    Definitions:

    Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities.

    Pioneered by Freddie Mac in 2013, credit risk transfer (CRT) programs structure mortgage credit risk into securities and (re)insurance offerings, transferring credit risk exposure from U.S taxpayers to private capital.

    "AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."

    An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.

    A mezzanine tranche is a small layer positioned between the senior tranche (mostly AAA) and a junior tranche (unrated, typically called equity tranche).


    WHAT ARE THE RISKS?

    Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.