Its greatest allocation was to banks at 45.0%, followed by 27.6% in corporate bonds.
Speaking at the BCI Global Investment conference, Wood indicated that investors seem to have very different responses to using credit within their fixed income allocations.
‘I run into investors across the spectrum – those that think credit is too risky to invest in and that fixed income managers should stay away from it, and those who are incredibly complacent about credit investing and think the yield is a slam dunk and should be banked in portfolios on an ongoing basis,’ said Wood. ‘I think the reality lies somewhere in between.
‘Like any other asset class, one needs to evaluate its potential for yield and return, as well as the risk and volatility investors, are likely to encounter. You also have to remember that if you are allocating to credit, you are taking capital away from another asset class. So, it has to earn its place in a portfolio.’
Understanding the risks
Wood said it was important for investors to be aware of the risks associated with credit. The first to consider is default risk.
‘This is the type of risk that gets everyone a little nervous about credit because it’s quite asymmetric: you either get your money back or you don’t,’ said Wood. ‘It can be quite binary.’
However, this risk can also be over-stated.
As Wood said, according to credit rating data covering global credit markets, the probability of default for A-grade rated credit over a five-year period is 0.7%.
‘That probability of default obviously increases as you go down the quality spectrum, but in the investment-grade space it’s quite manageable, and the numbers are not intimidating.’
He added that it is also not given that a default results in a 100% loss. Creditors will often see some recovery, and that can be quite substantial.
The average expected loss for single A-grade-rated credit over five years is 40 basis points, considering both the probability of default and the potential for recovery.
Credit ratings do, however, change over time, and these probabilities could change too. It is also important to be cognisant of the likelihood of an issuer retaining their credit rating over the life of an investment.
In the case of A-grade credit, there is an 86.75% chance of that rating being retained over five years. For BBB-grade, it is 83.44%.
The second, and perhaps more pertinent risk when investing in this asset class, is credit spread risk.
‘It is akin to a listed equity price going up or down, or a bond yield going up or down,’ said Wood. ‘The macro backdrop to the credit market changes, and that causes volatility and unrealised losses or gains as spreads move around.’
Spreads can widen quite dramatically in this space, and this was clearly evident during the Covid-19 crisis. Bank AT 1 credit spreads, for instance, widened from around 380 basis points to more than 500 basis points over the risk-free rate in March.
Ultimately, credit has a slightly different risk-return profile to government bonds. The graph below shows global data on the return distributions for government Treasurys and global credit.
(Click to enlarge)
‘Credit tilts slightly to the right,’ said Wood. ‘The average monthly return is 0.7% per month, against 0.4% from Treasurys.’
What he highlighted, however, was the value at risk. Both Treasurys and credit have around a 5% probability of losing more than 3% in any given month.
‘But where it gets more interesting, is that for Treasurys, on 99% confidence interval, you only have a 4% drawdown. Credit goes down to a 13% drawdown. There is that tail risk in credit where things go badly and money gets lost, where things get taxing for credit investment.’
Overall, however, credit is actually more defensive.
As the graph below indicates, credit lags all other fixed income asset classes when looking at historical maximum monthly returns. On the downside, however, maximum monthly drawdowns from credit have been far lower, and negative returns far fewer, than for the other asset classes.
(Click to enlarge)
‘There is an opportunity in this asset class, although there are risks,’ said Wood. ‘But if those risks are clearly defined and managed, credit will be a substantial enhancer to a fixed income portfolio from a diversification perspective, a correlation perspective and total return-enhancement perspective.’