Bond quality increasingly important in the wake of economic uncertainty, credit crunch

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The current unsettled economic environment is starting to take a toll on bond quality — particularly in the high-yield space. However, there’s still value to be found in the bond sector when portfolio managers account for credit risk and limit bond duration.

“People often associate widening credit spreads — the extra yield that a corporate bond pays over government bond yields — with a recession,” says Ian Marthinsen, portfolio strategist, Lysander Funds Ltd., an independent Canadian investment fund manager. “But we don’t need to know whether Canada or the U.S. are already experiencing a bona fide recession. Credit spreads can widen simply because we’re experiencing a stressed credit scenario.”

And there’s plenty of credit stress in the market, resulting from uncertainty about the economy and the stock market — and rising interest rates.

With the U.S. Federal Reserve posting its fifth consecutive hike, at 50 basis points this December, it’s becoming more costly for corporations to access credit. That’s not a problem for companies who have locked in favourable long-term rates. But it represents a significant challenge for companies who are issuing new debt or need to refinance existing debt.

According to estimates by Moody’s, United States corporate debt maturities will total US$785 billion in 2023 and US$800 billion in 2024. Some of that debt is in high-yield bonds that was issued in the previous low-interest-rate environment that made it easier for companies to access cheaper capital.

“This is where credit quality matters,” Marthinsen says. “Seasoned bond holders understand that when bond yields — the amount a bond pays each year in interest — rise, the price of the bond itself decreases. If you don’t hold the bond until maturity, you would have to sell it at a loss. The lower down the credit quality spectrum you are, the more sensitive the price of your bonds are going to be as credit spreads widen.”

However, the inverse relationship between bond yields and prices is still confounding to many investors. Marthinsen likens it to someone who lends $10,000 to a friend and bases the terms of a five-year loan on a five-year government bond.

If government bonds are offering 5 per cent, the lender assumes the personal loan is riskier than a government default, so they offer the money at 6 per cent — a credit spread of 1 per cent, he says. If the lender asked for their money back after one year, the borrower would point to the five-year term of the loan.

“If the lender needed the money now, they could sell that debt to another lender,” Marthinsen says. “But in a stressed market environment, that loan may be perceived as more risky than it was when issued. Let’s say that there were no takers at 6 per cent — only at 7 per cent. Since you can’t change the yield you would have to reduce the actual price of the bond to compensate the buyer under that widening credit spread scenario.”

In today’s unsettled environment, Canso Investment Counsel, the portfolio manager for certain Lysander Funds, looks back to historic credit spreads to inform current investment strategies. Looking back at the high-yield index, opportunities were evident in high-yield sub-investment grade bonds when the average spread for high-yield bonds stood at 500 basis points.

“We’re around 500 basis points now,” Marthinsen says. “Depending on your investment thesis, you could say that, since we’re at average spreads, maybe there’s some good opportunity here. But Canso would say that spreads could widen further and given the current environment of high inflation and lots of uncertainty, there’s probably more downside catalysts than upside catalysts right now.”

He notes that Canso may see one-off opportunities in the high-yield sphere, but it typically tends to enter that arena more broadly when there are plentiful opportunities. That typically occurs when spreads are much wider or are challenging previous peaks that were reached in previous credit drawdown cycles — say 800 to 1000 basis points.

At the same time, Canso is cognizant of duration risks and uncertainty regarding long-term inflation. By selecting bonds of shorter duration with similar yields to those offering longer duration, Canso seeks to mitigate exposure to the risk of future inflation.

“What Canso is advocating in this sort of environment is active management that seeks to be tactical in reducing not only credit risk, but interest/inflation rate risk as well,” Marthinsen says. “That’s why we believe it’s not a bad time for bonds — just a bad time for conventional bond strategies.”

For more information on Lysander Funds, visit: www.lysanderfunds.com

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