Commentary: Excess yields — trading credit strategies are a risky business

We have entered a more volatile macroeconomic environment and, in turn, a more challenging investment landscape. However, in our view, market dislocation also gives rise to significant opportunities to generate attractive, and often outsized returns.

Many investors are now considering how they can adjust their credit allocation both to protect portfolios against a likely recession while still generating attractive and steady yields in a rising-rate environment.

During the initial wave of COVID-19 and more recently following Russia’s invasion of Ukraine, European liquid debt markets, consisting of leveraged loans and high-yield bonds, faced increased challenges of wider spreads and volatility in secondary trading, with primary issuance effectively grinding to a halt.

While much public discourse focuses on the primary market, many investors are now arguing that dislocation in the secondary market presents an attractive buying opportunity, which could result in yields in excess of longer-term trends. For instance, between December 2021 and April 2022, yields in the European leveraged loan market rose to 4.4% from 3.4% (S&P LCD European Leveraged Loan Market index), while European high-yield bond yields increased to 5.4% from 3.1% (Bloomberg Pan-European High-Yield Total Return index).

These yields are reflective of high-quality credits being sold at significant discounts, mostly due to negative market sentiment, even though most of the issuers are still likely to meet their obligations. Additionally, the floating rate nature of most leveraged loans is viewed by many as attractive in a rising-rate environment.

Even in the fixed-rate market, buying opportunities exist for attractive credits where a refinancing or sale is expected in the short- to medium-term.

At the same time, with significant sell-offs in equity markets, investors are attempting to rebalance portfolios that have been over reliant on equities during the bull run of the past decade and are now reconsidering the role of credit strategies within their portfolios. In particular, pension funds will be assessing how they meet their long-term obligations to their members.

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