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9 questions about credit investing | Question 1
Is cash still king?
Last year, predictions favored bonds but rising interest rates led to modest bond market flows. Contrary to expectations, 2023 became a year dominated by cash, with record inflows into money market funds and short-dated treasuries, offering investors 4-5% returns without credit or duration risk.
So far in 2024, government bond and credit markets have delivered positive total returns, buoyed by signs of a soft landing for the US economy. As flows typically follow returns, we have seen investors starting to move from cash into credits. This trend poses a critical question: is cash still king, or do credits offer a more compelling alternative?
Investment grade and BB-rated credit offers better return potential
First, investment grade and BB-rated credit offers an attractive yield pick-up over cash, especially in an environment where we expect central banks to stop hiking rates and eventually start easing them. And it does this while protecting investors against future rate cuts that would immediately reduce the return on money market investments. Within the high-quality credit space, the return prospects, particularly for short-dated credit, look increasingly attractive as investors can lock in higher yields than cash for the next 12 months with limited interest rate or spread risk.
Money market funds and short-dated, short-term government bonds have been viewed as a lucrative place to park cash with yields north of 4%. Yet history has shown that these instruments have not been the best place to be when central banks eventually pivot to policy easing.
Comparing the performance of short-dated corporate bonds with money market investments and longer-dated aggregate bonds in periods following the last rate hike by the Fed reveals some interesting trends. As shown in the figure below, on average, short-term corporates outperformed money markets by an average 300 bps over different investment horizons (holding periods). Longer duration bonds (US Aggregate) delivered higher returns, however, with increased duration risk, meaning that longer duration bonds would be more impacted if we continue to see interest volatility.
Short dated bonds have historically outperformed cash
Source: Robeco, Bloomberg, July 2024. Performance over de 6-maands-, 1-, 3- en 5-jaarsperiode volgend op de laatste verhoging van de federal funds rate in voorgaande verkrappingscycli van de Amerikaanse Federal Reserve. De startdatums van de zeven periodes zijn 9-1-1984, 10-1-1987, 3-1-1995, 6-1-2000, 7-1-2006 en 1-1-2019.
Investment grade credit stands up in recessionary environments
Second, investment grade and BB-rated companies should be able to perform well in a recession. Although our base case is a soft landing for the US economy, markets have ignored and consequently not priced in the (tail) risk of a US recession. As history has shown, rate hiking cycles by central banks almost always lead to a recession, with the most recent exception being the 1990s. However, even in a recessionary environment with mild negative growth, investment grade credit and cross-over credit (BB-rated credit) should be able to outperform money market investments.
There are parts of the credit market that are more vulnerable if the economy goes into a recession, but investment grade and BB-rated companies will continue to do well even in an environment of moderate negative growth. These companies, with their conservative debt levels, can weather the impact of a recession on profitability and higher interest rates. They also typically have more longer-term debt outstanding, meaning there is no short-term risk of having to refinance at higher rates.
Better diversification of risks
Thirdly, moving from cash to investment grade and cross-over credit allows for better diversification of issuer risk. Typically, money market investments comprise more concentrated holdings in a small number of issuers or counterparties and while these issuers are of high credit quality there can be significant exposure to only a few issuers.
Investing in high quality investment grade and BB-rated credits allows for more diversification across issuers. For example, in our Global Credits – Short Maturity strategy we invest in more than 130 different companies across the global investment grade credit market. Furthermore, we would not advocate a passive approach to investing in credits, as this exposes investors to potentially lower quality companies with a higher risk of default. Investing in credit markets is about avoiding the losers through active management and fundamental bottom-up research.
