By Alex White FIA C.Act, Managing Director, Co-Head of ALM at Gallagher
Population growth and faster communications mean there are just more nodes interacting, generating more output. And climate change, especially given it’s so non-linear, throws another spanner in the works. The world is changing, and changing fast.
That’s not necessarily a bad thing. Plenty of change is positive, such as medical advances. If you accept that there’ll be more change though, what’s not in much doubt is that there will be both some winners and some losers- more change means more dispersion.
For an equity investor, this is fine. In an extreme example, if half the index doubles and half the index falls to zero, overall performance is neutral. You can live with holding some of the losers as long as your portfolio is diversified, and you also hold some of the winners.
For investors in credit though, the same picture is much less rosy. If half of companies win and half fail, investment grade credit investors would gain less than 1% on half the portfolio and lose about 60% on the other half, ending up down around 30% overall.
Obviously this is an extreme example, and default rates are unlikely to be an order of magnitude higher than they were during the Great Depression. But with spreads well below 1%, it doesn’t take many defaults to wipe out any gains. And, crucially, it highlights that there are two ways we could end up having more defaults- we could have a bear market where everything fares worse; or we could have more dispersion, more big winners and more big losers, with returns more differentiated. Markets can all do badly, or some companies can win big while others lose dramatically.
I find that using this lens makes clear the sort of bet you make when you invest in credit. For me, fundamentally, it’s this:
Investment grade credit is a bet that things won’t change that much
With the corollary:
Ten-year Investment grade credit is a bet that things won’t change that much in the next ten years
In some ways credit is protected. If markets struggle, corporate bonds are likely to continue to pay out, so credit offers security against even fairly large bear markets. But in a world with more dispersion, the best way to protect yourself is to have a portfolio that has some upside potential too.
If the world is changing faster than ever, we should have more winners and more losers- in short, more change. Investment grade (IG) credit is a bet that things won’t change that much; and long-dated IG is a bet that the world won’t change that much even over a long time. My questions for IG investors right now are therefore:
How big a bet do you want to take on the world not changing too much?How much do you need to be paid for that bet to be good value?Does your portfolio reflect your answers to the first 2 questions?
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