The trillion-dollar study credit managers don’t want you to read

It's safe to say that credit managers DO NOT want you to read the study we share here. It’s a Christmas cracker to be discussed over the BBQ this summer. In trying to diversify portfolios, are asset allocators actually adding risk using credit?

In our recent wire, ‘Don’t get barbequed this Summer’, posted on 22 Nov, we noted corporate credit debt melted in Quarter 4 of 2018, and is showing explosive negative price asymmetry late in the economic cycle. 

We believe credit is unlikely to be a truly defensive (or liquid) asset to counterweight equity holdings into 2019/2020 as the policy settings for credit are now highly unfavorable. 

As asset allocators think ahead into the coming years, the role of credit within portfolios is hugely topical. So - does credit help or hinder portfolio returns inside a balanced portfolio on a risk-adjusted basis? 

The Norwegian Sovereign Wealth Fund (Norges) holds more than $AUD 1.3 trillion dollars in assets. Some nations have larger foreign exchange reserves which are managed for official purposes (no regard for profit maximization), but Norges is one of the largest for-profit sovereign funds globally. It is also a highly transparent organisation. When Norges makes a major change to the fund, it is tabled at national parliament and voted accordingly on behalf of the people.

Recently Norges completed a study into optimising their equity-heavy portfolio with reference to fixed income allocations, and how to best complement riskier asset holdings (equities). The findings are stark for corporate fixed income, which show a strong historical positive correlation to equity excess return (increasing equity risk), while moving in a counter fashion to excess returns on Treasuries (Government bonds). 

In short, corporate bonds do NOT defend and protect against equity allocations but magnify the equity outcomes.

If you are expecting your corporate fixed income to be ‘fit for purpose’ and if 2019/2020 turn out to be nasty for markets, you need to consider the report below. This is a publicly available study completed by an institution with more than $AUD 1.3 trillion at risk.

“Credit risk and interest rate risk must be separated, and credit risk should be avoided in an equity-heavy portfolio"

JCB has long argued that credit risk and interest rate risk should be separated.

This is best practice in European and North American markets but is only just gaining traction in Australia. This separation gives asset allocators the option to underweight or overweight Government bonds or corporate bonds depending on investment cycle dynamics and portfolio role required. 

This Norges study goes a step further and suggests corporate bonds should be avoided altogether in an equity-heavy portfolio, as the risk/reward payout for additional risk assumed in corporate debt is superior if held in equities, on a risk-adjusted basis. To balance this additional equity risk, long duration sovereign Government bonds should be added to portfolios. 

In summary

Don’t get burnt in corporate credit late in the cycle as asymmetric negative convexity outcomes are looking likely dead ahead into 2019/2020.  The performance of corporate credit in Quarter 4 is likely only the opening act in a multi-year problem.  With further global rate hikes and more quantitative tightening expected ahead, plus peak global growth likely behind us, the credit cycle is hotting up quickly.  Liquidity is poor. Price action is weak and most importantly the policy settings are very unsupportive.

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Read the original article

We recommend reading this paper fully. The link to the article is attached.

We have summarised the highlights for you here.

• Corporate bond excess returns have historically been positively correlated to equity excess returns.
• Historically, corporate bonds earn positive excess returns over Government bonds, but a good part of excess returns disappear, once adjusted for duration.
• Norges Bank Investment Management studied a history of duration matched return of Treasuries vs corporate bonds and found:
  • Statistical significance of excess is greatly confined to the early part of sample period, when volatility of corporate bond excess return was particularly low;
  • Corporate bonds deliver very different excess return across maturity buckets. Most of the poor performance is concentrated in long-maturity corporate bonds. Short-maturity corporate bonds earn meaningful returns; and
  • Corporate bonds add some value over Treasuries in a pure fixed income portfolio. However, excess return and statistical significance disappear once equities are introduced into the portfolio. In 60-40 Equity-Treasury portfolio, corporate bonds reduce risk-adjusted returns.
• Multi-asset portfolio properties of corporate bonds therefore depend crucially on the initial equity-Treasury (Government bond) mix.

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