The appeal of investment grade credit
In today’s market environment, investors face the challenge of seeking attractive current income without taking the risk. To solve this problem, we seek to find investment solutions that offer higher returns and diversification for the portfolios of Australian investors in the more senior and higher quality segments of the corporate debt and alternative credit markets. .
In this article, we examine the attractive attributes of an allocation to liquid alternative credit; in particular, why we believe that investing in Secured Loan Bonds (CLOs) offers a compelling investment quality opportunity and how a dynamic and flexible approach can capture value in various market environments.
LIQUID ALTERNATIVE CREDIT
Quality credit is not limited to traditional corporate bonds, as liquid alternative credit also offers products rated triple B or higher, including CLOs and real estate debt securities. While many investors struggle to find attractive income solutions in today’s market environment, we believe that certain classes of liquid alternative credit assets, particularly CLO debt securities, are attractive because they offer a performance premium over similarly rated corporate debt. From
As of June 30, 2021, this premium was 200 basis points for debt rated triple B.
In addition to attractive yields, CLOs offer protection against both rising interest rates and inflation due to their short duration of less than a year. From a credit risk perspective, CLOs also benefit from various structural improvements that significantly reduce the risk of default within their debt tranches.
We believe that the CLO debt market presents opportunities for value capture resulting from a high degree of price inefficiency, as these instruments are generally misunderstood by the broader market and can often reflect perceived complexity or illiquidity premium.
CLOs are very similar to a managed fund in that they invest directly in a portfolio of selected largely syndicated bank loans and are actively managed by a CLO manager. The bank loan portfolio is subject to investment guidelines, including sector concentration and rating limits, further diversifying the investment.
Investors hold securities issued so that they can invest in a particular tranche, usually issued with varying maturities, credit ratings and returns, depending on the investor’s risk / reward appetite. Having the ability to analyze the underlying asset pool, structure and manager of CLO securities is therefore essential for investing in the asset class.
Typically, these more esoteric asset classes have barriers to entry because they require:
- Technical expertise;
- An investment platform established to access and unlock the benefits associated with alternative credit markets; and
- A rigorous and cycle-tested risk management approach.
In short, we believe that managers with the right skills and infrastructure can unlock for investors the compelling opportunity for investment-grade liquid alternative credit defined by current yield, downside protection and value creation at starting from market inefficiencies.
DYNAMIC ALLOCATION APPROACH
We also believe that a dynamic portfolio allocation covering high quality corporate credit and liquid alternative credit is essential because, beyond the benefits of diversification, it also offers an additional opportunity to generate alpha. This can be done by shifting targeted exposures through active portfolio management, as changes in value between markets can generate attractive entry points into each asset class.
When the COVID-19-induced market turmoil accelerated in March 2020, the Federal Reserve took swift and decisive action to lower the federal funds rate to near zero and maintained its accommodative stance throughout 2020.
Investment grade corporate bonds, which have predominantly fixed payment schedules and are subject to significant levels of interest rate risk, subsequently benefited from falling interest rates alongside rising interest rates. other long-term strategies. Historically, the yield component of the base rate has been attributed to 84% of total investment grade bond yields since January 1999. While larger risk assets have continued to recover throughout the year. year, triple B rated loans and CLOs outperformed in the latter part of 2020.
Specific to the Ares Global Credit Income fund, we have repositioned the portfolio throughout 2020 based on changing market conditions. When the fund was created in May 2020, we initially rolled out the portfolio quality allocation in CLO debt securities rated single A and bonds rated triple B given the potential for spread tightening under the improvement of techniques within these segments of the credit market.
As broader risk assets continued to recover throughout the year, we took profits on our exposure to triple B-rated corporate bonds and turned to triple-B rated CLO debt. because the asset class presented a stronger relative value opportunity. Additionally, within the portfolio’s CLO debt allocation, we have dynamically allocated between new (primary) vintages and seasoned securities sourced from secondary markets to add attractive risk-adjusted returns.
Unlike 2020, investment grade corporate credit has lagged behind the broader market recovery in the first half of 2021, posting negative returns for the first half of the calendar year. This is due to the reopening of the global economy, concerns about inflation and a significant rise in interest rates have prompted investors to ask for higher beta and floating rate instruments.
At the same time, triple B rated loans withstood inflationary pressures and outperformed similarly rated corporate bonds due to their low variable rate duration profile.
Similar to loans, triple B rated CLO debt securities also benefited from a changing rate environment in 2021 due to strong demand for lower duration assets, strong technical data and a premium. yield of 100 to 200 basis points (bps) against corporate debt provided a wind of support to the asset class.
As demonstrated above, we believe that the CLO debt market presents opportunities for value capture resulting from a high degree of price inefficiency, as these instruments are generally misunderstood by the broader market and can often be misunderstood. reflect a perceived complexity or an illiquidity premium.
In summary, we believe that investing in CLOs offers an attractive risk-adjusted return opportunity for quality allocations.
Teiki Benveniste is the head of Ares Australia Management.