418: The new rules of global credit: finding an edge in a fragmented world

Speaker A: This podcast is intended for investment professionals only. All investing involves risk.

Speaker B: Hello and welcome to LNG talks. Global credit is back on investors radar. But the rules of the game have changed. Following the publication of our recent article on this topic, we'll explore the key themes in more detail. From higher yields and tighter spreads to the growing importance of integrating credit rates and regional insights. Joining me for today's conversation are uh, Ian Hutchinson, head of Global Bond Strategies and Radha Mathur, fixed income investment specialist who will share their perspectives on the dynamics shaping global credit markets. So first up Ian, you've recently written an article on the return of global credit. What do you mean by saying global credit is back?

Speaker C: In one sense, global credit has never gone away. But what we were trying to get at with the headline is that since 2022 in particular, credit's really shifted back up investors priorities. You can now get positive real returns earned by investing in credit. That just wasn't true a few years ago. The old equity mantra of Tina. So there is no alternative to equity that's dead. Today investors, they're being paid a much higher yield than a decade ago. Corporate fundamentals, default rates have been really resilient. And so we've got that combination of high yields combined with resilient credit quality in our view make global credit an attractive area within fixed income.

Speaker B: So Radha, most comebacks happen in a different era to the one they've left. Global credit may be back, but this isn't necessarily a return to the world investors were navigating a decade ago. What's different about today's backdrop?

Speaker D: So in 2022, global yields rose. A lot of investors will remember the UK gilt market turbulence around October 2022. But this very much was a global phenomenon. So since then we've been very much operating in an environment of higher rates where higher yields are very much driving that renewed demand for credit. So we've got this environment where there's higher yields but also higher inflation, higher growth, particularly coming out of the US but also higher interest rate volatility. And that's quite different to to the environment that we saw between the period of 2010 to 2020, which was largely categorized with lower rates but higher credit volatility. We now see something quite opposite which is higher rates but lower credit volatility. Credit spreads also remain incredibly tight even with rising geopolitical tensions and higher government bond yields. So with this market backdrop and an environment where those higher rates are very much the normal returns are not driven solely by falling rates, but looking at credit selection and Dispersion as some of the examples are going to become increasingly important for finding ways to generate alpha. Ian, is there anything you'd add that

Speaker C: sums up where we are so well? Um, but uh, I'm a real kind of student of history so I think it's probably interesting just to delve into a little bit where we come from and why that environment's changed. If we look at credit for most of the post great financial crisis era we've had periods of higher and lower credit volatility. But this credit volatility almost always occurred against the backdrop of historically low rates, volatility and falling yields. Um, this is caused really by disinflation. This neutered the need for rate hikes as most western economies struggled for growth. With the collapse of a credit bubble and consumer demand. It was a period that a lot of investors dubbed the Ice Age. You had low growth, low inflation, low real returns for many asset classes. Government bonds generally did pretty well in this period. Um, but it wasn't seen as an enticing environment for um, yield hungry credit investors. Um, this all ended with COVID well not Covid itself but the government response to the crisis. So the economic response to lockdown was to provide massive fiscal fiscal stimulus either in the form of furlough claimants in the UK or stimulus checks in the us. This was all facilitated with government borrowing. Um, this was what academics had theorized for years as helicopter money to stimulate the economy. So economic theories would suggest or stipulate what would happen if you threw money from a helicopter. It would be the most direct way of putting it into consumers pockets and it would be hugely expansionary. Um, well it worked. This created inflationary pressure of the kind that central banks hadn't seen for decades. They were initially slow to react, um, but with supply constrained first by Covid, uh, then by the conflict in Ukraine and this year by Iran, input prices increased. While Covid checks got spent. Demand and prices rose and yields went in the same direction. The dam finally broke in 2022 with yields rising around the world.

Speaker B: At first glance tight spreads might suggest there's limited value left to uncover. But you argue in the article that the real story lies beneath the surface. What can investors be potentially missing here?

Speaker C: It's true that spreads are historically tight, but I think the last four years of demand it shows us that there are many, many buyers of credit where the focus is much more on total returns, whether that's real or nominal. Um, and when you look at the yields available, market valuations seem a lot more Compelling. So most market yield across global investment grade or global high yield, even emerging markets, they're all typically in the 50th to 75th percentile range over the last 20 years or so. And that's a level that a lot of investors find compelling. Um, we've repeatedly seen that even during periods of market volatility, demand can return quickly when yields are sufficiently attractive. Headline spread levels. They also mask an element of underlying sector dispersion. Differences in valuation across issuers, sectors and regions. They continue to create meaningful opportunities for active investors. In our view, selectivity is increasingly important. The gap between the most expensive and the cheapest areas of the credit market is substantial. So for us, alpha is less about broad market exposure. It's more about identifying relative value opportunities. Whether that's the issuer, the sector or the regional level. The overall opportunity set may still be rich, um, but that means it requires a more selective and differentiated approach than simply just owning credit. Beta.

Speaker B: So where do you think active investors can still find an edge?

Speaker D: So in general, our, uh, investment philosophy is built on the belief that we can add value by taking advantage of inefficiencies in fixed income markets. Whether that be behavioral biases, constrained investors, or focusing on overlooked fundamentals. We believe this presents opportunities for active managers to try generate alpha in all types of market conditions. With this particular market backdrop, we believe there's still sufficient dispersion to drive outperformance. And with spreads being so tight, as Ian mentioned earlier, it's really important to focus and really embrace the idiosyncratic risk opportunities as well as take advantage of the full breadth, um, of credit research expertise to help identify areas of value and also mitigate risks. Another really important lever is active rates management and ensuring that there's a process that looks at, uh, interest rate risk and how that affects credit returns as well as being its own source of alpha. Within portfolios, the goal very much isn't just to own more credit, but it's to ensure we're owning the right credit. And blending that with an active rates process that can help boost returns and dampen, um, volatility.

Speaker B: You've outlined where the potential opportunities are. But what could challenge the case for global credit from here? What are the key risks investors should be watching most closely?

Speaker C: There's always, you know, many risks to credit markets, but I think the ones that, uh, investors should keep that closest eye on, whether in a world where rates volatility remains high but high yields are really explaining a lot of the demand for credit. I think the key threat to credit returns is likely to come from a big shift in rate markets. If the market moves m suddenly materially higher risk appetite will likely fall. Um, although possibly that's only temporary. Um, but if rates fall too far, that could be a more persistent problem for credit demand. Geopolitical risk remains much talked about, but outside of uh, major supply shocks, the start of the Ukraine conflict or the Iran conflict, this year investors have shown willingness to look through those events. For example, credit volatility this year in the face of conflict is lower than last year's Liberation Day tariff induced selloff. Um, I think one final thing um, that we should just keep an eye on is hyperscaler supply. Credit um, markets are generally very good at absorbing large amounts of supply, um, even if it's from new sources. Um, but just the sheer scale of the capex within hyperscalers is something I think investors should keep an eye on. Um, in 2024, AI related supply was about 2% of US investment grade market. Um, so far this year it's about 18% and we think that's only going to increase. So I think that's something that also needs to be navigated with care.

Speaker B: You argue that the next phase of global credit investing will favor integration rather than silos. What does that mean in practice and how does it shape the way you're managing global credit portfolios today?

Speaker D: Yes, so we touched upon this point a bit earlier, but we're very much operating in an environment where we're seeing higher interest rate volatility and also higher yields that are driving the demand for credit. So in that environment, having active rates management is incredibly crucial to the process. But it also doesn't make a lot of sense to have different processes and teams for your credit risk and rates risk. But instead ensuring that specialists are uh, working together to form a very disciplined focus that takes into account the impact of rates risk on credit risk and vice versa, is incredibly valuable. The second point there is very much that as credit markets continue to evolve and diversify, having local market knowledge is incredibly key, but also ensuring that we maintain strong risk management process. So our solution to that is very much to have a hybrid approach where we allocate capital out to regional teams to benefit from their local market expertise. This also enhances alpha generation and portfolio diversification. But we also retain capital to manage risk, implement our duration strategies, but also ensure that we can um, amplify the strongest themes from those various regional teams. And what this does, it creates a holistic approach where we're ensuring that allocation selection and duration management can be their own independent sources of alpha, and we're not operating within any form of silos.

Speaker B: Looking ahead, what do you think will separate the winners from the losers in global credit over the next few years?

Speaker C: I think we operate in a world where uncertainty and volatility, they're not temporary disruptions, they're the norm. Um, so the winners in global credit are going to be those with broad toolkits, robust investment philosophy and processes, and flexibility to adapt as market regimes change. So being agile, nimble as credit managers, instead of predicting, that's going to be key. I also think that those investors that can articulate and act on their philosophies will be the winners in global credit. Understanding where you have an edge is crucial if you're planning to have sustainable alpha, you should ask yourself, where's your right to win? Is your edge likely to be persistent in a world of AI shifting flows? So having a clear focus on what you're trying to achieve means that you're best able to adapt to changes in the market structure and information technology. None of us knows what the future is going to hold, but I think it's so important to face it with clarity and with foresight for those hoping to thrive.

Speaker B: Great. Thank you so much. Well, I'm afraid that's all we've got time for today. Thank you both for your time and for a really insightful conversation.

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