Global Fixed Income

Weekly discussion of fixed income market action and what it may mean for investors.

March 28, 2017

Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

Is There Value in Credit?

  • With taxable credit spreads near their lowest levels in the past five years, is taking credit risk still a good choice today?
  • Given the run-up (appreciation) in credit, the opportunity for meaningful upside performance has diminished.

What it may mean for investors

  • We believe that higher quality credit-focused bond holdings continue to be a fair bet for well-diversified investors with a longer-term perspective (who are willing and able to experience increased near-term volatility).
  • We currently recommend that investors move up in credit quality. Within that context, we recommend an underweight allocation to high-yield debt.

Credit spread is the additional yield a fixed-income investor receives over the risk-free rate of return. Mathematically, this is calculated as the difference between the yield on a Treasury security and the yield on a fixed-income security outside the Treasury sector that is equivalent in maturity but not in credit quality. In recent years, with interest rates at very low levels, many investors have accumulated significant credit-sector (and credit-spread) exposure as a way to increase the income generated by their fixed-income holdings. Like all fixed-income investors, investors in “credit-focused” holdings such as corporate, high-yield and municipal debt can be impacted by changes in interest rates. However, investors in the credit market also can be impacted by changes in credit spreads. Over the past year, credit spreads on taxable bond sectors have meaningfully tightened (declined) as investors bet on fiscal stimulus and better economic growth. With taxable credit spreads near their lowest levels of the past five years, is taking credit risk still a good bet today?

Credit spreads tend to increase during periods of uncertainty as investors question the stability of debt payments from lower-quality issuers. In general, as credit spreads increase, bond prices fall—leading to poor performance for current holders of fixed-income credit investments. This phenomenon can be seen in Chart 1. Over the past five years, there have been two significant periods of uncertainty in the credit market. These include the Greek Eurozone crisis, and more recently, the collapse of energy prices in early 2016.

Since the lows in oil prices early last year, investors have been building in more optimistic growth scenarios. This improvement accelerated on the back of President Trump’s unexpected victory in early November. As Chart 1 illustrates, recent spread tightening over the past 12 months has been meaningful in a historical context. The Bloomberg Barclays U.S. Corporate Bond Index (of investment-grade bonds) currently trades at a 112 basis-point spread, while the Bloomberg Barclays U.S. Corporate High-Yield Index currently trades at a 401 basis-point spread.

Chart 1. Five-Year History of Credit Spreads on Investment-Grade and High-Yield Debt: 2012-2017Chart 1. Five-Year History of Credit Spreads on Investment-Grade and High-Yield Debt: 2012-2017Source: FactSet, Wells Fargo Investment Institute; March 27, 2017. (Bps = basis points. One hundred basis points = one percent.)

Given the run-up (appreciation) in credit, the opportunity for meaningful upside performance has diminished. At this time, we do not expect significant spread widening as the current U.S. economic expansion should continue, which, in general, should be supportive of the balance sheets of most credits. With that said, given the relatively limited upside in credit, we do not believe that investors are getting paid to take on incremental credit risk today. The spread differential between the Bloomberg Barclays U.S. Corporate Bond Index and the Bloomberg Barclays U.S. Corporate High-Yield Index is currently just 289 basis points, which is 67 basis points lower than the five-year average.

Income remains a meaningful consideration in fixed- income allocations, and reducing credit exposure can be problematic for investors with income needs. We believe that higher quality credit-focused bond holdings continue to be a fair bet for well-diversified investors with a longer-term perspective (who are willing and able to experience increased near-term volatility). Given the relative value across the credit spectrum, we favor moving up in credit quality at current levels.

It is important that investors maintain a well-diversified portfolio and avoid excessive exposure to lower-rated credits. Longer-term, lower-quality and smaller-sized holdings typically have less liquidity than those with the opposite characteristics. It is worth emphasizing that we do not see an illiquidity event in the near term, but such an event is likely to be difficult to anticipate. A change in investor sentiment on below-investment-grade credits could be triggered by any number of factors, and investors who hold high-yield debt should be willing to accept such an event.

Investor Recommendations

High-quality corporate debt can allow fixed-income portfolios to generate yield through exposure to high-grade credits. We believe that high-grade corporate debt offers investors better liquidity than can be found in most other credit holdings. Yet, the sector appears to be fully valued; even more so when considering increased leverage ratios. We continue our bias toward higher quality in the current market. We hold a neutral view on investment-grade corporate credit, but investors may consider seeking more favorable structures with more seniority. In our opinion, these holdings offer attractive income potential in a market segment that we believe offers better liquidity (than other sectors). We favor domestic financial issuers in view of the environment in which they operate. Investors may look for larger and more liquid issues to help mitigate risk.

We believe that tightening credit spreads and fundamental factors currently in play lead to a meaningfully asymmetric risk profile for below-investment-grade credits—with limited upside and the potential for significant downside risk. We believe that the risks in high yield are significant relative to the reward being offered. We currently recommend that investors hold an underweight allocation to high-yield debt.

Is there value in credit? Ultimately, value is in the eye of the beholder. In our opinion, value and credit should not be used as synonyms in the current market landscape.

Risk Factors

Investments in fixed-income securities are subject to market, interest rate, credit/default and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Definitions

Bloomberg Barclays U.S. Corporate Bond Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity, liquidity, and quality requirements.

Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt.

An index is unmanaged and not available for direct investment.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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