In its quarterly credit outlook for the first quarter of 2020, investment manager Robeco notes that portfolio construction is becoming more complex as renewed central bank liquidity continues to drive the search for yield.
“It seems we are not the only ones being a bit more careful in risk-taking,” the investment manager said.
“The high-yield market has had a good year, but BB-rated credit has again outperformed CCC credit ratings or distressed – and now we see cracks in single Bs. Popular credit products, such as multi-asset credit or ‘MAC’ funds, may be vulnerable to trouble in the leveraged loan market. There is a bid for safety but a need for yield.”
According to Robeco, there are very few high-yield bonds trading at the average index spread. The difference between BB- and BBB-rated bonds is close to a once-in-twenty-five-year tight.
“The reason is that the search for yield – quite sensibly – has been accompanied by a search for quality or safety. That means the other half of the market – B and lower – trades at relatively wide levels,” the investment manager said. “There are no bonds in the middle.”
That makes portfolio construction more challenging.
Many high-yield investors are moving into off-benchmark bonds, according to Robeco, while some end clients are giving up liquidity by allocating further to private markets.
“The risk is they could end up stuck once the bear market begins. Positioning is the main risk in credit markets now, for the short term.”
With significant growth in the leveraged loan market, Robeco is warning that cyclical excesses in US dollar leveraged loans are one of the most vulnerable parts of the entire global credit system, given the lax underwriting standards.
“Over US$600 billion of leveraged loans have ended up in CLOs – but both loans and CLOs have ended up in multi-asset credit (MAC) portfolio products,” the investment manager explained.
“Now, there is nothing ‘wrong’ per se with the broad concept of securitisation, with long-term holdings of well-structured AAA CLO tranches or indeed credit products that allocate across sectors looking for opportunity.
“The problem is that, as the long bull market progressed, the underwriting standards in loans became too lax, and the leverage too high. The liquidity of the underlying assets is likely to be highly variable over the cycle – and in 2019 major regulators and central banks have leaned on some of the world’s largest financial institutions not to participate in the market anymore.”
Robeco warns that if the loan market shows more cracks, it is easy to force spill over effects to the high-yield markets.