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Thoughts on the Role of Credit in Institutional Portfolios

June 14, 2017  | by James Meisner, Vincent Kravec

Asset Allocation | Fixed Income

While most institutional portfolios have allocations to investment grade corporate credit, as a strategic allocation high yield and emerging market credit (liquid credit) are sometimes overlooked. Yet these sectors can deliver attractive performance relative to other asset classes over long time periods with the potential for strong cash flow and diversification benefits as well.

In our last blog we discussed private credit as a way to access the potentially significant liquidity premium in an intermediate term and cash-flowing strategy. Liquid credit investments also offer strong return potential without the need to lock up capital.

Over the past 20 years, U.S. dollar-denominated emerging market bonds (including sovereign, quasi-sovereign and corporate bonds), as represented by the Bloomberg Barclays EM USD Aggregate Index, have been one of the strongest performing sectors, outperforming even equities over the past twenty years, as illustrated in Exhibit 1. High yield U.S. corporate bonds, as represented by the Bloomberg Barclays US Corporate High Yield Index, have also outperformed most equity indexes over this time period, with considerably less volatility.

Exhibit 1
EX1-AssetClassTotReturns

Of course, credit doesn’t always outperform equities and indeed we would generally expect equities, with their theoretically unlimited upside, to outperform credit investments during prolonged market rallies. For example, in the years since the financial crisis, the U.S. stock market has been a stellar performer, as Exhibit 2 illustrates:

Exhibit 2
EX2-AssetClassTotReturns

The 30-year bull market in Treasury bonds has certainly been a tailwind for the credit markets (and it has arguably had a salutary impact on equity markets as well). However, on a duration adjusted basis, both high yield and emerging market bonds have significantly outperformed Treasuries over the time frames considered above. Based on data provided by the Bloomberg Barclays index service, U.S. high yield corporate bonds have outperformed Treasuries on a duration-adjusted basis by an annualized 210 basis points since 1997 and by 555 basis points since 2009. For dollar-denominated emerging market bonds, the story is similarly attractive, with annualized outperformance of 362 basis points since 1997 and 333 basis points since 2009.

Is this the right time for credit investing?

Some investors are concerned about making credit allocations at this late point in the credit cycle. While it is true that these indexes have had a nice run, with spreads relatively tight and well inside their long-term averages, they remain significantly wider than the extremes of 2007 (see Exhibit 3). At the end of May 2007, the high yield bond index spread stood at 238 basis points versus 364 basis points today, and the EM bond index spread was 143 basis points versus 263 basis points today, suggesting that spreads remain reasonable albeit not generous. Credit can continue to benefit from its relatively high yield but there is arguably only limited longer term upside from spread compression.

Exhibit 3
EX3-Spreads

Who are your co-investors/managers?

In recent years retail investors have piled into high yield, loan and emerging market ETFs and mutual funds. This behavior can in some cases result in the funds/ETFs becoming price takers on bond issues, as the portfolio managers seek to put the latest subscriptions to work, while not necessarily being able to complete the same level of diligence on issuers as they otherwise might have in a more normal environment. We seek to invest in these sectors via separate accounts rather than commingled funds, where possible, to minimize the impact of the liquidity needs of others on our returns, to allow for better transparency and to exert more robust controls over the investment program through stronger mandate terms than one might find in a typical commingled program.

As to managers, credit investing lends itself to a more active rather than passive approach, given the idiosyncratic nature of corporate capital structures and individual securities and the nuances of emerging markets. We seek to partner with reputable managers that have demonstrated the expertise to navigate the credit cycle and opportunistically move both within and among sectors, up and down the capital structure and among countries and currencies to maximize risk-adjusted return.

Conclusion

While an index-like approach to bonds has worked well in the past on the back of a 30-year bond bull market, we believe that given today’s low yields and the outlook for a continuing rising rate environment, investors such as endowments and foundations seeking to achieve the goal of CPI+ 5% should consider a well-thought out diversified allocation to liquid credit markets, which can be a good companion to both investment grade allocations and private credit investments such as direct lending to middle market companies.

Authors

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Vincent Kravec is a member of the Commonfund Asset Management Investment team and is primarily responsible for investment monitoring, manager sourcing, rebalancing and reporting for investment portfolios with a focus in fixed income and credit strategies. Prior to joining Commonfund, Vincent was with Lazard Asset Management as a member of the Fixed Income operations staff. While at Lazard he was a trading assistant on the Emerging Markets team. He was also a supervisor in Fixed Income Accounting and had responsibilities in trading operations involving allocating trades and resolving trade problems for corporates, treasuries, municipals, asset backs and FX trading desks. Previous experience includes positions at Morgan Stanley, Alliance Capital and Evaluation Associates. Vincent earned his M.B.A. in from New York University’s Stern School of Business and his B.A. from Fairfield University. He is also a CFA charterholder.
Vincent Kravec
Director, CFA
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James F. Meisner is a member of the Commonfund Asset Management Investment team and is primarily responsible for asset allocation, manager sourcing, due diligence, and investment monitoring for investment portfolios. He serves as a member of the Commonfund Asset Management Investment Committee. Prior to joining Commonfund, Jim spent twelve years at RBS Greenwich Capital, where he was Managing Director and head of research for the Portfolio Strategies Group. Prior to that, he was head of futures and options research at Yamaichi America and at Merrill Lynch Capital Markets. Jim began his business career at the Chicago Board of Trade, where he was involved in the introduction of options on bond futures. Earlier, he was an Instructor in Statistics at the University of Chicago Graduate School of Business (now the Booth School of Business). He received an AB in mathematics and an MBA in finance from the University of Chicago, and he completed coursework and examinations for a Ph.D. in econometrics as well.
James F. Meisner
Managing Director
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.