Since the start of the COVID crisis, rating agencies have downgraded more than $1tr of corporate issues across the global credit indices. According to Simon Baxter, portfolio manager in the AXA IM Buy and Maintain credit team, this has left high quality assets in short supply, at a time when demand is rising.
He says the concentration in high grade assets has created a difficult environment for both passive investors – who may have to navigate the intricacies of large fixed income index rebalancings when issuers are downgraded – and the UK pension fund industry more broadly.
“The ultra-low interest rate environment since 2015 has provided Corporate Treasurers with a strong incentive to increase the overall level of indebtedness in capital structures,” says Baxter. “This has resulted in a drop in the average credit quality of issuers, driving a large increase in the BBB component of credit indices, which now averages around 50% of the main credit indices.”
He points out that credit downgrades have been issuer and sector specific, exacerbating the existing problem of issuer and sector concentrations, as BBB issuers have moved downward and out of IG indices and A-rated bonds have migrated to BBB. Higher quality sectors, such as Housing Associations, represent an increasingly large percentage of the longer dated Sterling credit indices, which Baxter says is a worrying trend, given the correlation within the industry and the ratings linkage with the UK Sovereign.
“For the UK pension fund industry, which is particularly reliant on the higher quality, 10+ year and 15+ year A-AAA indices, this presents a serious challenge and comes at a time when there is increasing demand for high quality long-dated assets,” he says.
“Plans are increasingly putting cashflow-generating solutions in place, and there are more investors chasing less available, high-quality assets. The ability to source these rare assets, at the right price, remains key to achieving portfolio goals.”
Baxter points out that in the last two years a number of high-profile issuers have been downgraded and exited the high-quality GBP indices, including General Electric, Heathrow (Class A), HSBC (subordinated) and Wells Fargo (subordinated). In the Sterling market, the top 10 issuers now make up more than 32% of the 15+ year index market value, while 50% of the index is comprised of just 21 issuers – a mean issuer size of 2.4% per name.
“Fixed income investors now face the possibility that EDF, the 2nd largest issuer, may lose one of its two remaining A- ratings; this would increase issuer concentrations further and leave investors reliant on an increasingly concentrated asset class. Those investors passively following a benchmark approach may have a very challenging and potentially costly index transition to navigate.”
Baxter says these problems were highlighted in April and May 2020 when elements of the passive fixed income industry lobbied index providers to waive the usual month-end index rebalancing rules, due to an inability to efficiently transact credit that had suffered rating downgrades and was due to transition out of indices.
“A keen focus on diversification and an assessment of fundamental credit quality, as key inputs to portfolio construction, can help ensure investors are insulated from some of the negative biases of fixed income indices,” he says.
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