End of the credit cycle? Beware the benchmark

Major credit indices are fundamentally flawed; we believe this to be true. The basic premise upon which they are constructed is inadequate. The concept that a higher debt load results in a larger index weighting is offensive to even the most novice credit investor. Unlike the major equity indices, which are largely a reflection of the market’s valuation of companies‘ expected earnings capacity, fixed income benchmarks reward aggregate debt. Given the massive increase in debt issuance over the past 10 years, this should be very concerning to credit market participants. In fact, the Bloomberg Barclays U.S. Aggregate Bond Index raised the minimum debt criteria in 2017 from $250M to $300M as increased incentive to profligate borrowing.

Furthermore, the idea that fixed income indices are “passive” is largely a fairytale. Certainly, the financial capacity of any company to service its nominal debt load must be considered in determining its credit worthiness. Rating agencies make active decisions that impact which issuers will be included within a particular index and which ones will be left out. The credit rating decision is very much arbitrary and very much active. For example, giving one company years to reduce debt after a large acquisition while penalizing another immediately. They may see one industry as more defensive than another or give credit to companies that have larger scale while penalizing those that are smaller. Given the performance of the rating agencies, particularly in times of turmoil, there should be little comfort in credit ratings.

The critical flaws of the benchmark framework have been exacerbated by increased dependence upon them since the last recession. Behemoth asset managers in fixed income markets have increased the risk to investors. Their sheer size, a limited market liquidity environment and the comparative ease of modeling larger benchmark securities has resulted in a crowding effect in large capital structures. The increased adoption of passive investment vehicles to gain quick exposure to fixed income markets has also increased the risk to investors. This dynamic is readily observable when looking at U.S. investment grade spreads. The average option-adjusted spread stands at approximately 75% of the 10-year average for Bloomberg Barclays U.S. Aggregate Corporate Index, despite the fact that the credit quality of the index deteriorated dramatically over that time. The BBB weight within the index has risen by nearly 15% over that time to over half of the investment grade universe. This should be unsettling for credit market participants, as the market has begun to flash numerous warning signals of a potential recession.

Bloomberg Barclays and Securian AM

The current credit cycle is much closer to its end than its beginning. It is showing signs of either buckling under its own weight or being crippled by numerous tail risks that investors have ignored. Fortunately, credit markets are resilient, dynamic and often provide opportunity to investors who do not run with the herd. The key to managing and thriving the next slowdown is to rely on the fundamentals of credit investing, recognizing that credit rating or benchmark weight has limited correlation to actual risk in difficult markets. Furthermore, finding skilled managers, who are nimble in size, with attractive risk-adjusted performance will be crucial. It will likely prove challenging to avoid the most overheated parts of the credit market with a large asset base and poor secondary market liquidity.