Economic volatility can create aversion to some segments of the market and opportunities in others. We believe today’s environment requires a defensive mindset in preparation for a possible recession, but also readiness to capitalize on recovery.
A combination of municipal bonds, utilities and crossovers could help position investors well for both scenarios, while adding diversification to most fixed-income portfolios.
Utilities have historically experienced approximately 75% of movement in corporate spreads. In the five most recent spread widening periods, long utilities have averaged a 5.5% average outperformance over long corporates.
In addition, in the near term, utilities may benefit from government stimulus and increases in infrastructure spending, which increase the potential universe of investment opportunities to choose from.
Municipal bonds (munis) also tend to perform better than corporate credit during spread widenings because a smaller portion of their yield is tied to spread. With materially fewer defaults and higher average recoveries than corporates, munis are a defensive option for achieving yield and duration during an economic downturn. With correlations to US Treasurys and corporate credit of approximately 0.8 and 0.7, respectively, munis also have the potential to bring diversification to fixed-income portfolios, which often consist solely of corporate credit and Treasurys.
Combining these utilities and muni bonds can help position a portfolio well in a recessionary environment. During the five most recent spread-widening periods, a 50/50 mix of long utilities and munis have widened 45 basis points (bps) less, for an average outperformance over long corporates of 6.8%.
Why utilities and municipal bonds?
In our view, recession is likely to hit the US in 2023. Economic downturns often include a widening of credit spreads. Historically, defensive fixed income that has outperformed during spread widenings includes utilities and municipal bonds. Both can act as a hedge versus corporates in a portfolio.Utilities have historically experienced approximately 75% of movement in corporate spreads. In the five most recent spread widening periods, long utilities have averaged a 5.5% average outperformance over long corporates.
In addition, in the near term, utilities may benefit from government stimulus and increases in infrastructure spending, which increase the potential universe of investment opportunities to choose from.
Municipal bonds (munis) also tend to perform better than corporate credit during spread widenings because a smaller portion of their yield is tied to spread. With materially fewer defaults and higher average recoveries than corporates, munis are a defensive option for achieving yield and duration during an economic downturn. With correlations to US Treasurys and corporate credit of approximately 0.8 and 0.7, respectively, munis also have the potential to bring diversification to fixed-income portfolios, which often consist solely of corporate credit and Treasurys.
Combining these utilities and muni bonds can help position a portfolio well in a recessionary environment. During the five most recent spread-widening periods, a 50/50 mix of long utilities and munis have widened 45 basis points (bps) less, for an average outperformance over long corporates of 6.8%.
Chart 1 - total return during spread widening
Source: abrdn, Bloomberg, July 2022. Blended benchmark consists of 50% utilities, as represented by the utilities sector of the Bloomberg Barclays Long Corporate Index, and 50% municipal bonds, as represented by Bloomberg Barclays Municipal Bond Index. The long corporate benchmark is represented by the Bloomberg Barclays Long US Corporate Index. The total duration for the items being compared was set equal using Treasury overlays. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
In addition, regardless of the economic cycle, this is an area where we believe investors can seek to take advantage of market inefficiencies.
This behavior creates market inefficiencies in the crossover space, which can be seen in the disproportionate increase in spreads that occurs in the BBB to BB range (Chart 2). Credit spreads rise for each possible downgrade along the spectrum. However, the increase is materially larger at the arguably arbitrary BBB level due to the restrictions many institutional investors face. We see this inconsistency as a source of inefficiency.
Why crossovers?
We believe the crossover segment of the fixed income market — bonds close to the dividing line between investment grade (IG) and high yield (HY) — represents an opportunity to capitalize on recent volatility.In addition, regardless of the economic cycle, this is an area where we believe investors can seek to take advantage of market inefficiencies.
Market inefficiencies
Investors often have explicit constraints on their ability to continue to hold bonds downgraded from IG to HY. For example, insurance companies are subject to capital charges on HY bonds and typically unable to hold them. Such investment behavior can lead to “forced selling” or the adoption of a “sell-now-ask-questions-later” approach.This behavior creates market inefficiencies in the crossover space, which can be seen in the disproportionate increase in spreads that occurs in the BBB to BB range (Chart 2). Credit spreads rise for each possible downgrade along the spectrum. However, the increase is materially larger at the arguably arbitrary BBB level due to the restrictions many institutional investors face. We see this inconsistency as a source of inefficiency.
Chart 2 - sensitivity of changes in spreads
Source: S&P Global Fixed Income Research, July 2022.
Opportunities to find “rising stars”
Historic average price movements show a gradual tightening of prices following a downgrade. When a bond gets downgraded, price may temporarily drop below fundamental value, but over time return to equilibrium levels as the selling imbalance abates. As a result, crossovers have historically performed best during recovery periods.
“Rising star” opportunities that are one upgrade from IG are currently at a historical peak. In this environment, we believe it’s important to have the flexibility to purchase credits during the downgrade period potentially to provide attractive entry levels. Active credit selection can identify those bonds downgraded from IG to HY that are able to regain an IG credit rating (i.e., “rising stars”).
Opportunities to find “rising stars”
Historic average price movements show a gradual tightening of prices following a downgrade. When a bond gets downgraded, price may temporarily drop below fundamental value, but over time return to equilibrium levels as the selling imbalance abates. As a result, crossovers have historically performed best during recovery periods.
“Rising star” opportunities that are one upgrade from IG are currently at a historical peak. In this environment, we believe it’s important to have the flexibility to purchase credits during the downgrade period potentially to provide attractive entry levels. Active credit selection can identify those bonds downgraded from IG to HY that are able to regain an IG credit rating (i.e., “rising stars”).
Why crossovers and utilities/munis in tandem?
Crossovers and utilities/munis both provide diversification to credit and long credit strategies that are often faced with issuer concentration risk. In addition, these two strategies are complementary in nature given their tendency to over/under perform in different environments.Table 1: Comparing these two strategies
Simultaneously introducing higher yield from crossovers and risk mitigation from utilities could help improve portfolio performance. And a strategy that introduces some dynamism between the two could allow investors to take advantage of attractive crossover opportunities as they arise during a potential recovery.
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Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.
Duration is a measure of the maturity of a bond or portfolio of bonds that takes into account the periodic coupon payments. It attempts to measure market risk, or volatility, in a bond by considering maturity and the time pattern of interest payments prior to repayment. Two bonds with the same term to maturity but different coupon rates will respond differently to changes in interest rates. So will bonds with the same coupon rate but different terms to maturity. The higher the duration, the greater a bond’s price-sensitivity to changes in yield.
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IMPORTANT INFORMATION
Diversification does not ensure a profit or protect against a loss in a declining market.Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.
Duration is a measure of the maturity of a bond or portfolio of bonds that takes into account the periodic coupon payments. It attempts to measure market risk, or volatility, in a bond by considering maturity and the time pattern of interest payments prior to repayment. Two bonds with the same term to maturity but different coupon rates will respond differently to changes in interest rates. So will bonds with the same coupon rate but different terms to maturity. The higher the duration, the greater a bond’s price-sensitivity to changes in yield.