Quarterly Update

Charles Luke, Managing Director, Senior Portfolio Manager | Oct. 2020

Stability of Opportunistic Credit Assets Is Remarkable

Market comfortable with growing level of defaults

Bonds advance despite pessimistic outlook for failures

Positive investor sentiment provides tailwind to credit assets

Opportunistic credit moved higher during the third quarter despite a rocky September for many risk markets. With election uncertainty, slimmer chances of additional federal stimulus and growing virus concerns, the stability of this asset class — driven by the demand for income in a low-rate environment — is nothing short of remarkable.

Global opportunistic credit rose 4.0% in Q3 2020 after surging 6.2% over the quarter through August.1 More than $4.2 billion in outflows from high yield bond funds in September led the market down 2.2% from its high, but in the context of over $60 billion in inflows since March, this is hardly a trend.2 We believe any weakness in the market is an opportunity based upon the lack of income alternatives. The yield differential between high yield and high quality exceeds the 2019 average by 1.1%.3 When combined with income demand, we believe this differential is a signal of positive return momentum through Q4 2020.

Regardless of the positive return outlook, default levels remain the key to market stability, yet we expect the number of failing companies to grow. In the worst-case scenario, Moody’s estimates that an additional 7.7% of the global high yield market will default over the next 12 months, peaking at 16.4% over the virus-induced credit cycle.4 However, these expectations suggest that the market is rising despite pessimistic forecasts, signaling tailwinds to positive returns due to high investor sentiment.

Despite rising failures, the advance of low-quality bonds over the quarter indicates the market is increasingly comfortable with default risk. In the U.S., CCC-rated debt climbed 7.4%, followed by B and BB bonds rising 4.5% and 4.0%, respectively.5 Energy and retail sectors account for nearly half of trailing 12-month defaults, creating opportunities in sectors with greater stability and protection from virus impacts.6 We believe that the concentration of failures in virus-related companies insulates the market from broad distress, and we continue to view rising defaults as a lagging indicator of forward returns.

Footnotes:

1Bloomberg Barclays Global High Yield Total Return (LG30TRUU)

2JP Morgan

3Bloomberg Barclays Global High Yield OAS (LG30OAS)

4Moodys

5Bloomberg Barclays Ba US High Yield Total Return (BCBATRUU), Bloomberg Barclays B US High Yield Total Return (BCBHTRUU), Bloomberg Barclays CCC US High Yield Total Return (BCAUTRUU)

6JP Morgan default report

Key Points

Market comfortable with growing level of defaults

Bonds advance despite pessimistic outlook for failures

Positive investor sentiment provides tailwind to credit assets

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All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.

Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

Alternative investments are speculative, entail substantial risks, offer limited or no liquidity and are not suitable for all investors. These investments have limited transparency to the funds’ investments and may involve leverage which magnifies both losses and gains, including the risk of loss of the entire investment. Alternative investments have varying, and lengthy lockup provisions.

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Index Definitions

The S&P 500 Growth Index measure growth stocks using three factors: sales growth, the ratio of earnings change to price, and momentum.

The Dow Jones U.S. High Dividend Yield Index serves as a benchmark for income seeking equity investors. The index is designed to measure the performance of 80 high yield companies within the S&P 500 and is equally weighted to best represent the performance of this group, regardless of constituent size.

Bloomberg Barclays Municipal Bond Index is a market-value-weighted index for the long-term tax-exempt bond market. To be included in the index, bonds must have a minimum credit rating of Baa. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least 1 year from their maturity date.

The Bloomberg Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market.

Indices are unmanaged and one cannot invest directly in an index.

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