Adam Whiteley, Head of Global Credit at Insight Investment visited Australia this week and I was very fortunate to be given the opportunity to interview him. Our focus was on the relative value of corporate bonds, also known as credit. Read on to learn about how he views current credit spreads, why he isn’t investing in private credit and why it’s important to invest globally.
Elizabeth Moran (EM) So, Adam, can you tell me a bit about your views on global credit markets at the moment?
Adam Whiteley (AW) Sure. So, if we start with the economics. We’re expecting positive growth, probably a bit below trend. We’re expecting inflation to come back down towards central bank targets, albeit, it’s a more bumpy path from here, and tariffs would be a potential wild card.
Those two factors will largely determine the tone for credit markets. And with a positive outlook given falling inflation, central banks, will be using policy rates, but probably, with the US Federal Reserve, at a slower pace than some were expecting.
So, it’ll be a bumpy path. Rates are expected to go down, not because central bankers want to stimulate the economy, but because they just want to remove the current level of restrictiveness. In a historical context, that combination would be supportive for risk assets, and credit spreads, by extension. But we also need to look at valuations, where a lot of that positive news is already in the price.
Value in credit at the moment is very much in the eye of the beholder. If you’re looking at it as a yield story, which is what many asset allocators would do, income is at 15-year highs, give or take. That’s a very powerful story, because credit can be offering a combination of diversification, income, and in the higher risk areas of credit growth.
But if you’re just focused on the spread, then it’s definitely below average. And you might argue that markets are complacent, but equally, we would argue that it reflects a very solid starting point for corporate fundamentals, where actually, most businesses are in good shape.
EM Great. Have you seen much volatility in the market, and in credit spreads, or is there generally compression across the spectrum?
AW So this volatility question’s a real puzzler, because you’ve got very high volatility in interest rates, and currency markets. You’ve got very low volatility action in credit spreads. That sort of disconnect tends not to persist.
We’d be of the opinion that the interest rate and the effect of volatility is not going to be coming down. So, the likely case is that the credit and the equity volatility moves up. Why you have that disconnect probably comes back to some of my earlier comments. There was a lot of money that’s flowed into fixed income, and wants to own credit, they’re buying the yields, but for every dollar that gets invested on the yield basis, it supports credit spreads, and it suppresses some of that volatility, but also because of general corporate health.
Now, that’s not to say that there aren’t a lot of other ways of adding value within credit, beyond just the big sexy directional view. One of the key benefits of having a global approach, is that you can take advantage of all of the regional opportunities, different pricings between the regions. You can look across industry sectors, different opportunities and risks there. Much of what we do is the more bottom-up stock picking, where there is always something going on.
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EM Fantastic. So, if you’re seeing a lot of volatility in currencies, does that mean you’re investing in local currencies and hedging interest rate risk, or still investing in US dollars?
AW We’ll invest across a selection of different denominations of credit, but what we will always do is isolate the currency view, from the interest rate view, from the credit spread view. So, whenever we’re thinking about our currency exposures, the starting point will be to remove any unwanted currency risk. What should happen in the current environment is, given that currencies, they’re a release valve for a lot of the different economic trends, but also, the tariffs potentially there should be quite a lot of opportunities to take advantage of active movements in currency markets.
For a credit strategy, that’s not something that we believe is an appropriate thing to do, because most people want to own credit for the spread. They won’t want their asset allocation choice being affected by what we do within that. But if you were talking to us about a more unconstrained approach, then yes, we would see quite a bit of opportunity within currency markets at the moment.
EM Where are you seeing opportunity within credit?
AW Credit is much more about an idiosyncratic set of opportunities at the moment, so much more focused on that bottom-up stock picking. Three months ago, I’d have told you there’s a lot more opportunity in Euro-denominated credit, relative to US dollars.
That has changed for good reasons. We’ve had quite material developments in Europe over the last few weeks, particularly Germany, around their fiscal policies. Germany is the one place in Europe that’s been very fiscally conservative. It’s the biggest Eurozone economy. It sets the tone for everyone else.
What they’ve announced is that they want to re-arm, and that they’re happy to spend on infrastructure in a big way for the first time, in a very long time. So that’s changed the game. It’s probably increased growth expectations in Germany, as well as the Eurozone.
And as a consequence, not just equity markets, but credit markets have priced a lot of that in. The opportunity, on a cost currency basis, is not there in the same way as it was.
Other areas where we would see value is between different credit sub-segments. We think emerging markets are priced for perfection. They are likely to be in the cross-hairs of a lot of what’s going on in the tariff policy.
Where we do see some relative opportunity is within pockets of the leveraged finance space. Below market, for example, that’s a market that suffers from the interest rate hikes much faster than anyone else, because it’s a floating rate asset class. So as soon as the central bankers say, “Interest rates are changing,” the cost for that loan cohort either goes up, as it has done, or actually now, if we’re easing rates, they should be a key beneficiary.
EM So, just in terms of the loan market, are you an investor in private credit?
AW That’s an interesting one. We don’t have a big private credit business on the corporate side. We do quite a bit on the secure side. So private credit is in enormous growth, probably quadrupled in size in the last 10 years. For a lot of investors, that makes total sense.
You get that extra liquidity premium, which, if you’ve got a long term time horizon, you should try and access. But it’s having a number of different implications, the first of which is, private credit diverts borrowing away from the public, from bank lending channels, which is traditionally where people get their financing from.
The second is that private credit typically gives borrowers more flexibility. That, from a borrower perspective, is quite good.
The third one is that it’s compressing the illiquidity premium. Because when you’ve got all of that money chasing the same group of assets, pricing moves, so that illiquidity premium, on the numbers that we would look at, is probably halved in the last five years. It’s now about 1.5%. And that’s quite an interesting number for us, because 1.5% is the alpha that an active manager can ask, if they’re a top quartile manager.
And you don’t have to get that alpha by locking yourself into a private credit investment that, de facto, you are expecting to hold to maturity. It’s a topic that I find quite interesting.
EM We do as well. It’s going through massive growth here and a lot of investors are very interested in it, just for the outright yield, but don’t actually understand the background to spreads and illiquidity premiums contracting. So, I find it massively interesting, as well. So please, continue.
AW Coming back to those first two implications I referenced, so the lending getting diverted to different places, but also, that borrower flexibility, one of the other puzzles of this cycle is that you’ve not seen default rates increase as much as you would have expected, within the public subscription channel. A lot of that, we suspect, is the defaults not disappearing, just simply changing hands. That market looks most like the private credit market. You have seen default rates there increase in the way that you would have expected.
By its very nature, private credit is private, you can’t see what’s going on under the surface. And they have that flexibility for the borrower is the second implication. But a lot of the mindset is amend and extend, or pretend and extend.
So, you don’t see a default, but if you are re-profiled in a way that you either have your coupon changed, or your maturity extended, the present value of that investment has changed overnight, even if you are not formally marketing down the borrower’s ability to repay.
EM So you are obviously steering clear of private credit, at this point. And it’s interesting, because some of the private credit providers here have grown hugely, and have just recently had big investments from global players. But right at this point, don’t see the value in that market?
AW Private credit is a very distinct asset allocation choice that the client has to give us a mandate to own. We wouldn’t put that in a vanilla fixed income mandate, because the illiquidity aspect is not what an investor would expect.
Private credit will make a lot of sense for a lot of people over the right time horizon. But what normally happens when you get very big growth is that you get a lot of new entrants.
I’m sure that some of the players here are absolutely fabulous at what they do. But I’m also fairly confident that there’ll be a lot of average people entering. We were talking yesterday with some clients, and in terms of what features would you look for in a manager, when we’re going through a selection process, you definitely want experience, because you want them to have been through a default cycle. You want them to demonstrate that they’ve got a capability to do that workout process, where potentially, you’ll end up owning a business, if your investment gets turned into equity.
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And then, the other feature of private credit that’s different from public fixed thinking, is that you have to go out and originate your own deals. It’s not like public fixed income, where an investment bank says, “I’ve got this deal for you. Would you like to own it?” You have to go and find it.
And that means that you need a team that needs to go out and source good quality businesses to lend to, rather than just taking what arrives in your voicemail.
EM Fantastic. Really great. Just going back to, probably almost the other end of the spectrum, sovereign debt, government bonds. How do you feel about that sector at the moment?
And of course, there’s differences between countries, and their programs and things, but are you investing in government bonds for liquidity and yield, as well?
AW That’s probably where there’s more of the yield story, because it’s the government bond yields that have increased the most, relatively speaking, over the last few years. It’s also where there’s probably a lot more opportunity to pick off different relative value trades between the regions, as you point out, because you’ve got different economies with different sensitivities, different central bank reaction functions, and different market pricing.
So that’s an area where our rates team is very focused on trying to find those government bond markets, where we think yields have got further to fall, but they’re equally where we think, actually, they’ve probably fallen too much already. Thinking about closer to home here, we think there’s, relatively speaking more value in New Zealand government bonds, relative to US Treasuries.
Within Europe, we’d say that there’s probably a lot more value, but this has changed a little bit, but until several months ago, in German government bonds relative to Swedish government bonds, those sorts of relative value trades are quite interesting.
I’d say the other key theme in government bond land is the shape of yield curves. So you have a central bank that sets a policy rate, the overnight borrowing rate. But then you have a market that prices out the yield curve, two-, five-, 10-, 30-year, and we would expect yield curves to be steeper. So, you have underperformance of longer-dated government bonds, relative for shorter-dated bonds, shorter-dated will respond to the interest cuts.
The longer-dated bonds are going to be more vulnerable to this very loose fiscal policy setting, that actually most countries across the globe have got. And maybe some of those debt sustainability concerns that we’ve had a few fire drills of over the last few years. We think back to the UK, you had a crisis in 2022, French government had borrowing costs increased quite a bit last summer. You could point to emerging markets.
There are some warning signs. But it’s very difficult to have a base case that would have a run on a government bond market.
EM Absolutely. But with those government bond yields staying high or relatively higher than they’ve been, obviously, that’s impacting credit spreads, and a lot of credit is less attractive at this point.
Can you just talk about where you are seeing value, and how you might have traded a recent credit, to make the most of a volatile market?
AW So we think about credit in four different areas:
- The directional view, are you over or under-invested, compared to a neutral?
- Then what we call macro credit, relative value, and I’ll give you an example in a minute, as your asset allocation choice can be across regions, can be across all risk factors.
- There’s the industry sector strategy, are they in banks, rather than telcos?
- Then there’s the security selection.
So for that directional piece, we are modestly overweight.
That reflects the cycle analysis. I described the combination of the growth, inflation and central bank cycle that should be supportive for credit spreads, but we need to be slightly more cautious on valuations. Tactically, we are more cautious, again, because of all the insurgency on the tariffs.
AW That still does leave us with a modest overweight, though. So expecting that credit spreads can probably get a little bit more expensive from here, within that relative value piece and the asset allocation choices, relatively speaking, we do still see more value in European credit, relative to US dollars, not in the same way as I would have done three months ago, but we do still like that as a position.
Within the industry sector space, all the uncertainty on the economics, there’s actually very limited risk premium in any of single sectors, and that leaves us to a much more defensive bias, overweight in sectors like utilities. Security selection is about having, hopefully, lots of little winners.
I’m considering three different categories. It’s ratings momentum, for example, is a company going to be transitioning from high yield to investment grade, that’s a so-called rising star. They get rewarded with lower borrowing costs, and when that happens, bond prices go up. The second bucket is event risk. And that can be a double-edged sword. So you can have businesses that are going out and buying other businesses, and they’re using their balance sheets and credit ratings go down. We want to try and avoid those.
But equally, we’re seeing quite a lot of corporate reorganizations, which can lead to businesses having to repay debt early, and at a premium, compared to where it’s in the market.
And then, the third bucket is what I just described as risk premium, where you take a step back, and it’s just too cheap for what it is, you don’t know when that’s going to disappear. But as a strategic, and hopefully, patient investor, you can hope to own those sorts of positions.
EM That’s excellent. Is there anything else you’d like to talk about? We have covered so much.
AW I think probably the final two points that would be good to mention are diversification, in terms of regional versus global. So, when I was looking yesterday at the concentration of the domestic Australian corporate bond market, I think the top five companies made up 31% of that index. So, you’re not really getting diversification at an issuer level.
If something goes wrong in any of those, or indeed, anything just goes wrong domestically in Australia, you are fully exposed to those risks. It makes sense to diversify, take a more global approach. A global approach, not just diversifies, but it gives you all the opportunities across all of the regions, some of which we’ve touched on.
And then, the second one that would be good to discuss is, the misconception that active management doesn’t work, period. That view is absolutely relevant, if you’re looking at the large cap equity space, where the median manager struggles throughout the forum. Empirically, that is just not the case within fixed income and credit investing. The median manager averages probably 0.5% per annum of alpha.
So, there’s money on the table, but not simply being in a passive investment, where you are only earning the asset plus returns. And if we’re in a world of ongoing uncertainty, on economics and policies, that should keep volatility elevated. Volatility is just another word for opportunity, and that’s exactly what active management is.
EM In bond markets, it’s clear that there is money to be made by actively managing portfolios, whereas, in equities there really isn’t. Thank you so much for your time Adam.
