Tale of Two Investment Strategies
Written By: Kevin Price
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…” —Charles Dickens
While the differences between Investment Grade (“IG”) performance and Sub-Investment Grade (“Sub-IG”) performance may not contrast as starkly as those outlined by Dickens, they are notable. Sub-IG has outpaced IG from both fundamental improvements and total return. As seen below, Sub-IG names have been delevering much more rapidly than IG names over the past four quarters ending Q1 2021 and Sub-IG investors have been rewarded for these improvements.1
Throughout the COVID pandemic, on average, Sub-IG names, on both an absolute and relative basis, became more levered than IG names. Given that Sub-IG had more leverage, thus more room to run, we expected to see Sub-IG names delever more than IG names. While this has been the case, what is interesting is that Sub-IG’s delta between 2019 average net leverage numbers and TTM average net leverage numbers is 0.09, which is the same as IG. This delta divided by 2019’s average net leverage number is 2.25% for Sub-IG and 3.36% for IG.2 Our takeaway from this ratio is that Sub-IG is closer to pre-COVID net leverage ratios than IG.
Q over Q Net Leverage Reduction
As seen in the chart to the left, Sub-IG names have proven the ability to delever quicker than IG names.3
Sub-IG names have delevered 9.06%, since the high of 2Q 2020 through Q1 2021, while IG names have delevered 1.35% during the same period.
While Sub-IG names have had much more room to delever post-pandemic, these names have shown continued resiliency, noted through these improving credit fundamentals, throughout the pandemic.
The table to the right shows that Sub-IG names have been able to bring the average TTM net leverage numbers ending Q1 2021 to only 2.25% from what the average 2019 net leverage numbers were.
During the same period, IG names have brought numbers within 3.36% of 2019 numbers.
Both High Yield and Leveraged Loan indexes (both indexes are representative of Sub-IG names) have outpaced the Investment Grade index year-to-date (“YTD”). Additionally, the Investment Grade index is negative YTD.
Leveraged Loans have also proven to show much less volatility than both High Yield and Investment Grade Indexes.
Given the strengthening fundamentals of Sub-IG names, we are overweighting Sub-IG names versus IG names to take advantage of the improvements in this space.
Additionally, given the low interest rate environment that we are currently in, we are overweighting portfolios into Leveraged Loans versus High Yield. Leveraged Loans float above a base rate, which helps reduce duration risk.4
To learn more about our strategy, please reach out to Andrew Chipman at achipman@southernoakcap.com
1 High Yield, Leveraged Loan and Investment Grade Index performances as per Bloomberg. These YTD performances, as of September 13, 2021, are shown in the line chart at the end of the write-up
2 High Yield and Investment Grade index net leverage numbers are as per Bloomberg
3 Delivering data is as per Bloomberg. Chart starts with 2Q 2020 and ends Q1 2021 Shows cumulative delivering numbers
4 We use macroeconomic factors to help guide us on investment decisions. We could misjudge or miscalculate the macroeconomic environment and this could cause additional losses in the portfolio. We view the current interest rate environment as low, however, rates could drop and this would prove our macroeconomic thesis incorrect. Leveraged loans typically float over a base rate. However, many have floors that the loans already “float” over.
This means minor rises in base rates may not immediately, or at all, translate into higher interest payments. Additionally, the rate that the loan is floating over typically adjusts monthly or quarterly, in between that time period the rate is fixed versus floating. Given these dynamics and potentially others, leveraged loans could still take on some duration risk
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