By Daniel Dolan, portfolio manager of the iMGP US Core Plus fund and Managing Member of Dolan McEniry Capital Management, LLC
War in Europe, a supply-chain squeeze, and the shift to monetary tightening have created fresh uncertainty in credit markets. Irrational exuberance seems to have been replaced by irrational pessimism.
And, as a result, the market has become far more opportunistic. In our opinion, this is good news for active, long-term investors seeking high-quality assets at an attractive entry point.
The movement in fixed income spreads underlines the relative scale of opportunity. Before this year’s storm in bond markets, the two-year Treasury was at 25 basis points. Now it is at 336. The 10-year was at 147; now it is at 337. Meanwhile, corporate bond spreads, as indicated by the Bloomberg U.S. Intermediate Corporate Index, were at 58 basis points; today, they stand at 124. High yield (Bloomberg U.S. High Yield Ba/B Index) was 236; now at 413.
One particular statistic reflects just how extreme the bond market reaction has been. The historical spread between the Fed funds rate and the two-year Treasury has been 34 basis points since 1976. And there are those that believe the yield curve is way ahead of the Fed, if you assume that Fed Funds Futures are 348 in December – it’s clear the curve is expecting the direction of travel on rates.
Of course, there could be a little more downside for rates, but any potential upside of a position is, in our opinion, likely to be much greater than the first five months of this year. Thus, we now see the market taking an asymmetric shape where we believe the potential upside of a position is significantly greater than its potential downside.
Credit quality appears to remain strong
Credit risk does still lurk, but overall credit quality appears strong. If the Fed continues to raise rates, some experts have suggested the economy could slow and the possibility of a recession exists. If that were to occur, economists have suggested the Fed would again be put in a position where they must stimulate the economy. We believe yields and spreads are as attractive as they have been in three years, barring the pandemic sell-off.
The key to our credit analysis is an evaluation of free cash flow because, in our opinion, companies who generate it well and allocate it wisely make the strongest case for enduring value. We look at the free cash flow generated by a company and examine how it ebbs and flows through different market cycles. This seems to be a much better opportunity to access such companies.
Businesses that we like are consumer durable and non-durable, manufacturers, distribution, healthcare, retail, low technology, software and communications. The more prosaic the business, the more comfortable we feel in our ability to analyse its prospects. Across the investment grade spectrum, we are now picking up quality names trading between 175-200 basis points over Treasuries. In the high-yield space, we have been able to take advantage of yields approaching 7% – for example, one credit in aircraft parts.
If you go back to periods where there have been extreme credit events, the taper tantrum in 2013 for example, or the GFC in 2008, credit quality was, in most cases, much lower. In our opinion, the quality of credit in our portfolios remains strong, if not very strong, today.
In fact, the free cash flow coverage of interest ratio of our investment grade names is 10.7 times, which theoretically means you could cut the free cash flow in half and cut it in half again, and we will still collect our interest payments. In our high yield names, it is 5.4 times.
The corporate credits within our portfolios seem to have, in our opinion, wide margins of safety to avoid default risk. And we will attempt to take advantage of any decrease in credit quality and spreads in quality names that we already hold, if, as some economists warn, we were to lurch into recession.
Benjamin Graham once said, “The intelligent investor is a realist who sells to optimists and buys from pessimists.” The present macro headwinds have created plenty of reasons for investors to be fearful. But with a clear and patient mind, we see the current volatile market as an opportunity to access quality credits at historically wide yields and attractive price discounts.