The three key market biases we seek to exploit in global credit

It is an unsurprising fact that many investors err on the side of caution, often seeking both positive returns as well as relative safety. However, the pursuit of higher returns can mean accepting more risk.

Fixed income index investing aims to square that circle, offering clarity and certainty of low default risk while promising the returns from investment grade (IG) credit.

Index investing clearly has a place in portfolios, offering cost-efficiency and diversification[1] among other potential benefits – and L&G is a proud pioneer of systematic approaches more broadly. In this blog, we discuss standard credit benchmarks that do not benefit from L&G's pragmatic replication approach, which aims to overcome some of the known limitations of standard benchmarks.

For investors who favour an active approach, we see opportunities for strategies to exploit certain constraints resulting from biases embedded in the underlying market indices.

The three main constraints we have identified are: forced selling of issuers when downgraded to non-investment grade, regional limitations and an overweighting toward the world’s most indebted companies. We discuss each one – and how we seek to take advantage of them – below.

1.      Forced selling 

The defining feature of an investment grade index is that it may only hold IG bonds, with those issuers with credit rating downgraded to BB+ or lower being sold at the end of each month. Therefore, investors who stick rigidly to a particular index become forced sellers of these bonds when large numbers of other sellers emerge, increasing supply and reducing demand.

This constraint means safety from further downgrades can be achieved, but this can potentially be done at the least advantageous time – meaning an investor could be overpaying for this insurance.

However, an active investor can exploit this constraint in the following ways:

• Using fundamental research to try to stay ahead of rating agency downgrades
• Deploying relative valuation frameworks to assess the value of credits nearing BB status. Often these bonds can offer some of the best risk-adjusted value in the entire credit universe, as the short-term weight of forced sellers distorts their true value
• Seeking to use market timing to choose the point of our own exit should we not wish to hold the bonds over a longer term. We believe the combination of these three methods can create a powerful, sustainable source of outperformance opportunities

2.     Regional constraints 

There are similar potential opportunity sources for the global active investor, such as regional bias.

Many, if not most bond indices are benchmarked to a single region, reflecting the behavioural home bias of many investors or that domestic regulation encourages them toward. This creates distortions in valuation that the global active investor is free to benefit from by buying the cheapest bond from a global issuer regardless of currency.

Home bias is real, but temporary. As chart two shows, most (around two-thirds) of the world’s biggest companies regularly issue debt in both US dollars and euros.

The valuation each domestic buyer base places on a single company’s debt can vary substantially at any one point but over time both values tend to revert to an average. This occurs because of different levels of regional investor familiarity with the companies’ activities or differing regional investor preferences for certain sectors.

While these conditions do emerge, they tend to mean revert over time as issuers of new debt are drawn to issue more in the more expensive (for the investor) market. An expensive (low) yield for an investor is a cheap (low yield) opportunity for a borrower.

Thus, these opportunities tend to mean revert over time. Global active investors can look to spot these valuation differentials as they emerge and try to re-weight a portfolio toward the better risk-adjusted return and await the mean-reversion.

3.     Owning under-researched issuers

Large issuers within an index are often better represented in terms of third-party research, while smaller, less well known and less liquid corners of the global credit opportunity set are neglected. Companies that are small in terms of total debt issuance only ever receive a small weighting in indices but may offer better risk-adjusted returns than the market as a whole. In our view, this knowledge is only discovered through detailed research.

A purely illustrative example is Athora*, a smaller issuer in the euro insurance market. Relatively unknown to most investors at the time of its inaugural subordinated deal in June 2024, it was forced to issue with a higher yield than its credit rating (BBB-) would suggest. As the chart below shows, the bonds have materially outperformed the broader market since issue and are currently on review for upgrade with Fitch.

Investors considering global credit should be aware that an overly constrained approach could potentially suppress the returns available versus risks faced.

We believe investors seeking strong risk-adjusted returns from global IG bonds should understand these constraints and how an active approach can help to seize opportunities created by them.

 

* For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an L&G portfolio. The above information does not constitute a recommendation to buy or sell any security. 

Assumptions, opinions, and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass.
 
[1] It should be noted that diversification is no guarantee against a loss in a declining market.