Understand emerging markets opportunities and the American Century advantage.
By Jason Greenblath & Rich Taylor - December 2019
Conditions in the U.S. credit markets are becoming more challenging as demand for U.S. corporate bonds continues to outpace available supply. Frustrated with negative and ultra-low yields in Europe and Japan, investors continue to favor higher-yielding U.S. corporate bonds. But companies are issuing fewer debt securities, fueling supply-demand imbalances and driving prices and valuations higher. Against this backdrop, credit spreads are tight, volatility remains heightened and many investors are moving up in credit quality as the economy slows.
Despite these challenges, we believe several active, research-intensive strategies remain viable, even as market sentiment turns increasingly defensive.
For chief financial officers (CFOs), the interest rate environment trumps the credit spread backdrop. See Figure 1. With interest rates near multiyear lows, many CFOs are looking to capitalize on the rate environment to cut their near-term financing costs. For research-focused investors, this dynamic offers the potential to generate alpha.
Specifically, we rely on our stringent credit research efforts to identify companies with stable or improving credit quality. Within this universe, we focus on select shorter-maturity corporate bonds with A and BBB credit ratings, above-market yields and “make-whole” provisions. In low- or falling-rate environments, company CFOs view these securities as ideal candidates for refinancing. They can pay off the bonds at a premium and reissue the debt at lower interest rates, thereby reducing their overall financing costs.
Bonds that include make-whole provisions allow their issuers to pay off debt early, as long as they pay bondholders a premium as outlined in the bond agreement. Bond issuers must deliver to investors lump-sum payments typically above the bond’s current fair value, based on the issuer’s current spread over the current Treasury yield. These payments are designed to make investors “whole” for foregoing future coupon payments. Make-whole bonds offer benefits for both parties. Bond investors may boost their portfolios’ alpha, while CFOs can improve their companies’ bottom lines.
The new-issues market provides another opportunity to pursue alpha. Often, new securities offer upside potential versus existing bonds. Similar to our strategy with make-whole securities, we focus on new issues from companies we have extensively researched—those we know, understand and like.
Backed by our proprietary credit-research insights, we’re often able to buy new issues at prices well below our estimates of fair value. If our insights prove correct, these bonds eventually will reach our fair value estimates, enabling us to sell them at a premium. In addition to the total return potential this strategy delivers, we believe this effort generally offers better risk/reward opportunities than seeking yield and performance potential from lower-quality securities.
Bond prices and yields and credit spreads tend to ebb and flow. Credit spreads have trended tighter recently, hovering near their narrowest levels in several years. See Figure 2.
Therefore, rather than buying and holding bonds and waiting for them to mature, we prefer to leverage the ebbs and flows—and the resulting credit spread movements—to boost total return potential. When a bond’s credit spread tightens and reaches our estimate of fair value, we’ll typically sell the security and move on to other opportunities offering more attractive valuations and performance potential. This commitment to remaining nimble helps create a balance of offense and defense in our investment-grade credit portfolios.
Similarly, in the high-yield credit space, we look for “rising stars” or select securities at the higher-quality end of the high-yield spectrum. A bond we designate as a rising star is one we believe is poised for a credit rating upgrade that would push it into the investment-grade universe. When that happens, spreads tighten and prices rise, thereby enhancing the portfolio’s total return.
With the U.S. economic expansion aging, we believe focusing on fundamental, bottom-up credit research is key to uncovering performance potential within our corporate bond portfolios. In today’s low-yield environment, credit spreads are tight, valuations are stretched and unlocking alpha remains a challenge. Our commitment to in-depth research and analysis on sectors and companies helps determine how securities may perform during various market cycles. We believe these insights give us an edge on offense without sacrificing portfolio protection.
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Monthly analysis of the global bond market.
As the credit cycle ages and corporate bond investors grow increasingly defensive, we believe select strategies may continue to deliver value.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.