Capturing opportunities in today's credit markets
Structural shifts in capital markets since the “Global Financial Crisis” or “Great Recession” have caused market dislocations to become shorter and more frequent. As a result, investors are choosing to outsource allocation decisions to managers with strong market presence that are better positioned to manage risk and capitalise on investment opportunities as market conditions evolve.
Chart 1 illustrates market dislocations that have taken place during the 2000s, as defined by periods when the credit spreads here represented by option adjusted spread (“OAS”) for the broader high yield market (measured by the ICE BofA US High Yield Master II Index) increased above 700 before returning to the historical median of 500. The Great Recession, along with prior dislocations, lasted two or more years. Conversely, spreads retraced within six months of the March 2020 dislocation. As market dislocations become shorter and more frequent, a dynamic and flexible approach has become critical to capturing attractive relative value opportunities that arise in episodic periods of volatility.
Chart 1: 2000 - Present Day, Market Dislocations
It is also worth highlighting that in non-traditional credit asset classes, active management is paramount to capture above benchmark returns. Unlike in equities or traditional fixed income, passive strategies in bank loans or high yield are often unable to adequately replicate benchmark returns due to model limitations. Over the course of 2019, 2020 and 1Q’21, the market presented very different investment environments. As illustrated below, during each of these periods, Ares was able to consistently outperform both broad market indices and larger ETFs in the loan and high yield sectors, underscoring the importance of a dynamic approach across asset classes but also active management within each of those sectors.
Chart 2: Active Management Remains Critical to Unlocking Value
2020: A Banner Year for Relative Value Investing
2020 was a complex, tumultuous year for global financial markets. We believe there was no single “trade”, as managers had several opportunities to generate alpha through active asset rotation and disciplined credit selection. Even as markets recovered from the March lows, the rate at which spreads retraced varied significantly across asset classes, rating cohorts, and geographies as market conditions evolved, presenting ample opportunity for managers looking to take advantage of inefficiently priced segments of the market.
Chart 3: 2020 Total Return by Asset Type
By actively repositioning our multi-asset credit portfolios as market conditions evolved throughout the year, we were able to capitalize on air pockets of volatility and capture relative value opportunities. Below is a summary of notable market themes during each of the periods illustrated above, and how we positioned our portfolios accordingly.
- Early Covid: After a strong start to the year, credit markets came under pressure in early March, as COVID-19 began to spread outside of China to the United States and Europe. As a result of elevated volatility, the Federal Reserve (“the Fed”) pre-emptively cut interest rates to near zero. In February, we raised cash across portfolios as COVID-19 became more serious to be well-positioned to buy any oversold investment opportunities.
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Covid Crisis: The global pandemic drove an economic standstill and as a result, global financial markets experienced a severe downdraft in late March. Amid heighted volatility, we rotated up in quality into high grade corporate debt, which sold off alongside sub-investment grade credit amid indiscriminate selling.
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V-Shape Rebound: Risk assets rallied as asset prices were buoyed by unprecedented stimulus from the global central banks. We took profits on our high-grade corporate debt exposure and rotated into investment-grade CLO debt securities given the long-run total return potential for the asset class and a yield premium to similarly rated corporate debt. While structured credit lagged the recovery seen in high yield bonds and bank loans, the asset class continued to make substantial gains since March lows amid improving technicals.
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Summer / Pre-election: Credit markets remained resilient and spreads continued to tighten while default expectations improved, as accommodative fiscal and monetary support overshadowed rising COVID-19 infection rates and elevated U.S. Presidential election uncertainty. We remained overweight corporate bonds and underweight loans, as bond technicals remained supportive amid strong primary issuance, fund flows and the Fed’s backstop.
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Risk Rally: The significant rebound from March lows continued as election and vaccine related optimism lifted investor sentiment, despite the resurgence of COVID-19 cases and social unrest. Most credit sectors traded at or inside pre-pandemic levels by year-end. Within our below investment-grade corporate debt exposure, we rotated into bank loans, as the asset class screened more attractive on a relative value basis than bonds, given their short duration, convexity profile and senior secured spread. In addition to the attractive yield, loans offer protection against both potential rising interest rates and a potential stalled recovery given the security of the asset class.
Our agile approach in 2020 underscores the importance of a dynamic and flexible approach in shifting market environments. Informed by quantitative analysis and fundamental research, our demonstrated ability to express relative value across the credit markets drove strong performance for our multi-asset portfolios in 2020.
Conclusion
The “sweet spot of credit” encompasses a $5.0 trillion opportunity set across the U.S. and European leveraged loan, high yield, and alternative credit markets. To be a successful investor in these markets, we believe one of the keys to success is to employ a dynamic approach with the flexibility to select the most attractive relative value opportunities.
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Ares are experienced credit evaluators who take a value-oriented approach, using fundamental bottom-up research to identify investments that offer attractive relative value in comparison to their fundamental credit risk profile. Stay up to date with all our latest insights by clicking follow below.
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Mr. Benveniste is the Head of Australia for Ares Asia Wealth Management Solutions and acts as a client portfolio manager for Australian investors. Prior to joining Ares Australia Management in January 2020, Mr Benveniste spent six and a half...
Mr. Benveniste is the Head of Australia for Ares Asia Wealth Management Solutions and acts as a client portfolio manager for Australian investors. Prior to joining Ares Australia Management in January 2020, Mr Benveniste spent six and a half...