We have reached a new paradigm: Credit investors are not being adequately incentivized to take on risk. The return per unit of interest rate risk, defined by yield over duration, is the lowest it has been in over 20 years — just over 1%.
That need not be a deterrent, but enhancing the return prospects of individual investors seeking yield calls for hands-on, agile, active management — and the more flexible the approach, the better.
Passive products are often rigid: They cannot freely color outside the lines. Passive funds that rebalance on monthly or quarterly schedules can be vulnerable to market shifts, especially volatile ones. Because benchmarks include the most liquid, widely available bonds, these funds are intrinsically linked to fund flows. They often buy what is most expensive as flows enter the market, and sell with many others as flows exit.
High-yield spreads have narrowed toward historical levels, at 321 basis points as of June 14, which means it’s difficult to make up for any mistakes and or losses. As a result, many credit managers have become more risk averse as their performance is often measured by how closely they mirror the market.
But this isn’t the usual active versus passive argument. Tracking a benchmark is certainly passive. Managing liquid credits to a benchmark through credit selection, and asset and sector allocation, or overweighting one sector over another, is just a slightly more active passive. Any manager can watch the markets and wait and see what comes across their desk.
There is a better way.
“The new active” is about realizing the dreams of every portfolio manager who has looked at a bond deal and said, “If they had made a few tweaks, it could have been much better for my investors.”
At firms with scale and flexible pools of capital, when institutional investors know a company well, they can go to bond issuers and ask them to create deals tailored to their specific needs. By collaborating with companies on customized capital solutions, investors can drive incremental value.
Done well, there is potential for substantial upside beyond what “wait and see” can deliver. Proactivity can be valuable, especially in this market. Opportunities can be created with downside protection and total return appreciation, in both the public and private markets, across debt maturities and capital structures.
Currently, the high-yield market is the cleanest and highest quality many of us have ever seen, with little overlap to the loan market and less exposure to the leveraged buyout community. There is far less credit risk in high yield than in the leveraged loan market.
The Federal Reserve helped protect the high-yield market. Last spring it stepped in to provide liquidity for large issuers and purchased fallen angels and high-yield ETFs through the Secondary Market Corporate Credit Facility program.
Yet small and middle-market businesses, along with many of the companies in the syndicated loan market, did not receive Fed support, directly or indirectly. Many borrowers may need or desire capital to play defense or offense over the near and medium term. This will create more opportunity for “new active” managers.
The more flexibility an investor has, the more ways they will be able to win in this market.
On the flip side, inflexibility can also cost investors. It often takes years after initial dislocations and drawdowns for all the downstream net effects of a market shock to manifest. Having the flexibility to adapt and adjust to a borrower’s needs can be important.
Every active manager with the right capital duration always has a timing advantage: They can react quickly to roiled public markets and invest opportunistically as new trends emerge, creating attractive risk-reward opportunities. Speed of execution gives active managers the ability to move with the market rather than react to it.
For example, the leisure sector took a significant hit as Covid-19 lockdowns began. Stress quickly impacted loans, investment-grade and high-yield bonds. At that time, high-quality BB-rated investment-grade bonds tied to big businesses with access to the Fed’s liquidity infusions were offering double-digit returns. Active managers seized these opportunities.
But daily liquidity vehicles were susceptible to outflows and in many cases were unable to play offense. These vehicles comprise approximately 50% of the market. As such, investors should expect volatility to be the new normal in the high-yield market given the equity-linked nature of these funds. It could also bring a bumpy ride when the Fed begins to taper.
In high yield, fund flows and security pricing move in tandem: When flows enter the market, returns have been positive; conversely, when there are outflows, price returns have been negative. This has played out routinely over the past two years, with March 2020 being an especially stark reminder.
“The new active” offers investors a way to potentially manage market volatility tied to equities and rates. In creating their own issuances with quality companies, new active managers can offer investors superior downside protection and enhanced returns — in all market conditions.
Chris Sheldon is a partner of KKR, where he serves as head of leveraged credit.