Credit Investors Face Challenges with America-First Approach

Written by James Crombie, a Bloomberg markets live reporter and strategist

Credit investors focusing solely on US assets may be overlooking superior returns in other parts of the globe. As the American economy slows and political risks increase, these investors are becoming more vulnerable to volatility and potentially poorer performance.

Global investors are often compelled to invest heavily in the US due to its liquidity. It represents over 57% of the high-grade index, an increase from 55% five years ago, and 62% of junk. However, more lucrative fixed-income opportunities exist elsewhere.

US assets are underperforming across all categories, from junk and high-grade bonds to leveraged loans. With the American economy decelerating and the Federal Reserve not eager to cut rates, the European Central Bank is expected to start easing this month.

US politics are becoming increasingly turbulent, posing a potential threat to credit markets that have been lulled into a false sense of security. There is an excess of money pursuing a limited number of American assets, with slim US credit spreads implying meagre future gains and minimal protection when conditions worsen.

European credit markets have an advantage as the ECB prepares to cut rates, which should benefit investment-grade bonds. There is more spread on that continent, but less overall yield than dollar debt given lower base rates.

The Euro junk index is of higher quality — more BB, less CCC rated — than the US. However, it is not without risk. Single B rated bonds in euros may seem relatively inexpensive, but as pointed out by my colleague Sebastian Boyd, net debt to Ebitda is increasing faster. This group is also plagued by large and highly-stressed issuers like Altice.

Moreover, Europe's macroeconomic outlook is less favorable than the US. However, a reduction in euro hedge costs for dollar-based investors to the lowest since November strengthens the argument for a geographical shift.

The top performer this year is Asian junk in US dollars, which has surged almost 9%. It has an index quality of Ba3/B1, trades at an average price of less than 88 cents on the dollar and a spread of 500 bps over Treasuries, even after a strong rally since October. This is in comparison to a price over 92 and just a 310 bps spread on US junk, which is rated one notch lower on average.

Asian high-yield bonds are inexpensive for a reason — the index is 17% real estate, much of it in China, which many foreign investors deem as "uninvestable." However, daring investors betting on the Chinese government resolving the property crisis could see significant bond gains.

Other large emerging markets also present opportunities, especially commodity-rich nations like Mexico and Brazil, where rates are also anticipated to drop faster than in the US. EM corporate debt in dollars has yielded more than 2.5% this year, rallying as equivalent US assets declined. It pays more than double the spread of US high grade for less duration and only slightly lower quality.

Traditionally, EM has offered higher returns due to the perceived greater political risk. However, the recent volatile years in Washington have arguably been equally tumultuous.

US credit investors have a plethora of concerns, ranging from commercial real estate stress and corporate debt defaults to inflation, recession, war, and elections. This only exacerbates the home bias, as portfolio managers tend to favor what's familiar — and liquid — in stressful times.

Apart from the complex credit work and analysis, those seeking geographical diversification also have to contend with liquidity constraints and currency hedging costs.

While America is too significant to be overlooked in any portfolio, credit investors are increasingly overweight US assets that appear extremely overpriced compared to history, and relatively rich versus other regions. They risk allowing American exceptionalism to obstruct consideration of other options — as much to generate alpha as to hedge the numerous risks emerging from the US.

What are your thoughts on this matter? Do you think credit investors are missing out on opportunities by focusing too much on US assets? Share this article with your friends and let's get a conversation started. Also, don't forget to sign up for the Daily Briefing, which is available every day at 6pm.