Tight spreads force caution, selectivity in credit markets

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Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Gino Di Censo, CIBC Asset Management director of global fixed income 

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How do you currently view the overall fixed income and credit market, and which segments — public or private — look most attractive and why? 

So I’d say both segments have pockets of attractiveness. When we think about public markets, spreads are certainly at historic lows, at levels we haven’t seen in almost a decade. 

Despite this, there are pockets of opportunity within certain sectors and maturities that can allow investors to capture decent yield pickup. But again, we do acknowledge that there’s definitely richness in the corporate bond market. 

Despite this richness, we have maintained an overweight in corporate credit through most of our portfolios, and this is predominantly in defensive sectors. So we are being cautious on risk, but we recognize there are pockets or abilities to add a higher yield than the benchmark through strong credit discipline. 

We are staying cautious on high yield and long-dated corporates, I will say, just given the spread tightness and richness in valuations. We think there’s better risk-adjusted returns elsewhere in the credit market. 

We think investment-grade corporate credit is still supported by strong fundamentals, but with spreads being historically tight, selectivity does matter. 

And on the private credit side, similar to public credit, we are looking for investments into more defensive parts of the market – think non-cyclical companies and companies with ongoing recurring cash flows that aren’t highly dependent on the health of the underlying economy. 

In our direct lending funds, for example, we tend to like sponsor-backed companies or companies that have a private equity backing because, in theory, with these types of companies, should the company face financial difficulties or have some trouble, the companies are often supported by the underlying private equity firm or sponsor, who also has skin in the game. And so we like investing alongside a private equity sponsor to help support a business should things go south or have trouble. In the private credit segment, those really looking for low risk, and are willing to compromise a little bit on yield, we also like the investment-grade infrastructure debt space, where you have these long-dated, critical infrastructure assets in a strong structural position and with well-supported cash flows. And so, for those investors willing to compromise a little bit on return, but want a very safe part of the private credit market, we think infrastructure credit — particularly investment-grade quality infrastructure credit — makes a lot of sense. 

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In public credit, which sectors or issuers are you favouring, and how are you managing interest-rate and duration risk? 

Within the public credit segment, our corporate exposure is really concentrated in shorter maturities, in strong companies, and in less-sensitive economic sectors. In our Core Plus funds, we have reduced high yield, and we have preference for defensive corporate, for example. 

In terms of how we’re managing extreme duration risk, I’d say, all of our benchmark-aware strategies or those that have a benchmark tied to them, keep a thoughtful eye on duration and we need to manage those strategies within certain parameters from a duration perspective. 

That being said, we do believe that tactical movements in duration can add alpha. We do believe that duration or interest-rate risk can be your friend in a backdrop of volatility and easing interest rate policies. 

And so, just to give an example, in 2022, interest-rate sensitivity was about 92% of the downside when rates rose drastically. We just look at the FTSE corporate bond benchmark. But in contrast to that, in 2023 and 2024, interest-rate sensitivity was 54% of your upside. 

And so, interest rate sensitivity to risk can be your enemy, for sure, but can also be your friend if managed appropriately. And so we’re being thoughtful, and do believe in tactical allocations or adjustments to duration can add value. 

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In private credit, what strategies and borrower trends are you prioritizing, and how are you balancing return versus liquidity and default risk? 

From a strategy perspective, senior-secured infrastructure lending, as I mentioned earlier, are areas where you have real cash flows and real assets and lenders that can hold pen on docs. And so, we believe these should be a key part of a portfolio. 

When we think about a single-ticket solution that can deploy capital opportunistically within different segments of the market, we think these are attractive, as well, for investors who really want to rely on a manager’s expertise to be an all-weather solution that can deploy capital opportunistically. 

And so, those portfolios may have the bulk of their assets within senior-secured private credit, which we think is a strong risk-adjusted return part of the market, but they can also allow a manager to opportunistically add something maybe more risky if economic conditions warrant it, or more safe if they feel that economic conditions are deteriorating. 

And so we are launching such a strategy, and we do think they’re a good solution for investors as well. I think it’s less about chasing broad beta in the private credit market, and more about finding places where we can add value. 

From a borrower perspective, we’re prioritizing predictable cash flows, essential services, contracted revenue and recurring revenue models, so stuff that can actually carry debt at today’s rates. 

When we think about balancing return with liquidity and default risk, we think you can’t maximize all three. It’s just the reality of it. You’re going to be compromising on one or the other. And I think if an investor firm is pretending that they can maximize all three, it’s where you could eventually get into trouble or gating, for example. 

And so as more money flows into alternatives, from a private client perspective, I think investors need to appreciate that these are inherently illiquid investments. And if a vehicle’s promising liquidity, they should understand where that liquidity is coming from. And in some cases, it comes from a sleeve of public bonds, which I think makes a ton of sense, but it’s just about really understanding where that liquidity is going to come from. And you know, at this point in the cycle, underwriting discipline and portfolio oversight are really what matter, more than maybe squeezing out another 50 basis points of return. 

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Where do you see the biggest risks in credit over the next six to 12 months? 

From a public credit perspective, I’d say the biggest risk is repricing around the soft-landing narrative. I think markets have baked in rate cuts and steady growth. In the U.S., for example, the market’s pricing in three to four rate cuts over the next year. But if inflation stays sticky, or fiscal pressures keep yields high, we could see renewed spread widening, especially in the lower quality parts of the market. 

If we do see economic weakness, the scope of monetary policy easing that both the Federal Reserve and Bank of Canada can do may be limited if we have inflation continuing to remain sticky, or fiscal pressure keeping yields high. 

Liquidity is another concern. There’s a lot of money chasing yield, and I’d say that goes for both public and private credit. 

And then isolating private credit, I’d say the biggest risk here is more about the lagging effects of higher rates, coupled with a still-quiet M&A market, and more and more money facing fewer and fewer deals. So a lot of money has flown into the private credit space. But the reality is it’s been harder for a lot of managers to deploy that capital. 

Ensuring you’re investing with a manager that is allocating appropriately, I think, is paramount. I think a lot of the 2020 and 2022 vintages were underwritten on aggressive leverage with possibly light covenants, and now we’re seeing some of those asset managers reporting stress building through some of these loans. And so, keeping a watchful eye on these parts of the market, I think, is paramount.

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