Speaking on the release of QIC’s Red Paper Au revoir credit beta: meet credit alpha, QIC’s Director of Fixed Income Research & Strategy, Katrina King, yesterday warned that institutional investors accustomed to strong returns from credit markets in recent years will need to re-think their current strategies or risk seeing the capital value of their portfolios eroded.

Ms. King said that while it is true that credit markets have been a strong source of capital returns in recent years and corporate bond yields are currently at their lowest level since the GFC, the economic environment is starting to change.

“It’s true that the situation today is still quite constructive overall, but as economic growth picks up and central banks move to normalise monetary policy, yields will gradually rise. Portfolios which simply rode the spread tightening of the past few years will be threatened,” she explained.

In Ms. King’s view, for institutional investors to benefit from corporate bonds’ yield advantage, they will need to take a truly active investment approach and look at removing both interest rate and inflation risk from their credit allocations.

“Inflation may be muted now, but it remains a worrying undercurrent,” she said. “Credit spreads have tended to rise when inflation uncertainty has risen. Investors have just lived through a lengthy period of ultra-low official interest rates which, while not our base case, carries the risk of causing an inflation outbreak.”

Ms. King said that at the same time, global economic conditions are improving, and businesses are responding positively. Shareholders are beginning to expect higher returns, which in turn puts pressure on management to take less risk-averse positions.

“I certainly don’t mean to suggest that companies are about to play fast and loose with their finances, but there is a definite sense that company-level risk is on the rise,” she said.

Long-only credit strategies, which have worked well over the past few years as global investors fled risk in all forms, are now less likely to perform. The next phase of the credit cycle will require much deeper analysis industry by industry and company by company to identify vulnerable companies as well as those with reassuring credit metrics.

Ms. King concluded that with the right approach to credit, investors have nothing to fear from the changing world order, and that truly active investors will find plenty of opportunity to exploit price gaps between industries as well as individual companies.

“At QIC our focus on outcomes has meant that we are happy to decouple from the benchmark and manage the three levers of inflation, interest rate and credit risk separately, in order to harness multiple alpha sources.”

“Current market conditions are calling out for this kind of unconstrained approach, including macro positions and long short trades between different indices in order to make the most of corporate bonds’ yield advantage,” she said.

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