In the current environment of historically low government bond yields, investors should explore credit markets to help meet their return targets. However, investment grade credit has become less appealing in the new investment paradigm, given its high exposure to duration.
The direction of monetary policy points to limited potential for rates to move lower, damaging the return potential of duration. In the US, rate rises are increasingly likely post-election; in Europe, the ECB is intervening in credit markets and may seek to control yield curves: both are negatives for duration.
We believe that in this new investment paradigm investors should move down the credit spectrum and consider the crossover “BBB-BB” segment. The crossover universe offers the potential for significant return enhancement when compared with investment grade along with robust fundamentals, while avoiding the excessive credit risk of the high yield universe.
With credit risk at the forefront, implementation is key. We believe that market-cap benchmarks are not equipped to deal with the new reality as they tend to concentrate risks by rewarding leverage.
We recommend that investors bring quality to the heart of the portfolio construction process to mitigate credit default risk and facilitate lower turnover – a framework utilised within our fundamental fixed income approach.