J.P. Morgan Asset Management’s Strategic Investment Advisory Group believes there are opportunities within the high-yield bond market, despite the risk still associated within that sector, the firm said in a recent report.
The report, entitled “A New Perspective for Credit Investors,” analyzes the investment opportunities within the public and private credit market and how investment-grade and high-yield securities are being combined.
High-yield bonds, also known as junk bonds, are known to pay higher interest rates, mainly because they run a higher risk of default than investment-grade bonds (and as a result tend to have lower credit ratings). However, that has been changing in recent years, according to Jared Gross, head of institutional portfolio strategy at J.P. Morgan Asset Management.
“The public credit markets have shifted to a center of gravity that encompasses the lower-rated end of investment grade and the higher-quality portions of high yield,” he said. “High-yield credit has moved up in quality ... over time [and] it has become a higher quality asset class with respect to its ratings.”
When the quality of the high-yield sectors declines, it’s likely because companies are being pulled up to investment grade and has less to do with an overall downgrade in credit, Gross explained.
“It’s important to recognize that the high-quality components of the sub-investment-grade bond market have improved in credit quality across time, and benefit from proximity to the investment-grade sector as rising stars have become more common in recent years,” he said. “This is no longer a punitive sector of the market where only weak companies wind up because they did something wrong,”
Companies are making a conscious decision to work in that high-yield sector by working with a higher level of leverage, which while consistent with their business model, could concern credit ratings agencies.
“These are companies who are choosing in many cases to operate with a certain level of balance-sheet leverage and a certain level of interest coverage that the rating agencies believe requires a high-yield rating,” Gross said. “This appears to be a conscious choice on the part of corporate managers to operate with higher leverage.”
However, investors and banks have demonstrated a willingness to fund those companies at that level, Gross explained.
The Growing Private Credit Market
The report also highlighted the growth of the private credit market and how it gives investors the opportunity to target higher total returns while supplying capital to riskier borrowers.
“All of that risk has moved out of the public market and into these private vehicles,” Gross said. “The structure of a private fund is more stable across time than a bank’s balance sheet, which can be subject to liquidity impact from depositors pulling funds.”
If firms with weaker balance sheets and stressed operating models can obtain more regular financing, it will more than likely lead to additional stressed and distressed situations taking place at a more consistent pace, especially in the higher rate environment, according to the report. It will present not only risk, but an opportunity as well.
The report said there are three credit market components investors may want to look at for permanent allocations: The first is ultra-high quality, which will be effective for duration and risk, the report said.
The second is the broad credit market, which will help investors with income and offer compelling, risk-adjusted returns with limited volatility. Finally, there is speculative credit, which brings together greater credit risk, leverage and/or illiquidity for potentially higher returns, the report said.
Gross said advisors should be focusing on getting a prudent level of credit exposure into their clients’ portfolio and capturing high, risk-adjusted returns.
He highlighted two ways they can do that: First, those with a core holding can increase its quality by simply adding a dedicated high-quality high-yield manager. The second method is by using a multi-sector credit or income strategy, which tends to operate in a more unconstrained way with respect to the investment-grade/high-yield divide.
In the speculative credit areas, he said it would be prudent for advisors using direct lending and private credit to expand their allocation to include secondaries and distressed credit as well.