There is a tide in the affairs of markets

Revealing lower valuations in credit markets

I spent a few days in Tofino recently, sitting at the beach, watching the surfers do their thing. Waves come in. Surfers ride the waves or splash into the briny foam. The next waves come in, and the cycle repeats. More persistently, however, the tide gradually pushes toward the beach. The bay swells with water. The beach walkers head home and the exposed rocks disappear below the surface. And then, slowly, gradually, the tide recedes.

As with the beach, so go the markets. We look at situations where the credit of a company becomes stressed or distressed. These situations either resolve themselves through re-pricing back to par, work out, or restructure. These are the waves of the credit market, and we are their surfers.

There are also tides in the market. Inflation, business valuations, and risk-free rates to name a few. These trends are themselves governed by forces seemingly as remote as the orbit of the moon is in relation to the tide. As the calendar turns to 2022, it may perhaps be useful to consider any potential shifts in the underlying tides of the credit market.

One tide that we are quite used to watching is the oscillation of credit business valuations, which manifest themselves in our market as credit spreads. A business with a higher valuation is deemed to have a larger equity cushion beneath its bonds. The bigger the cushion, the narrower the spread.

The market for business valuations, as measured by Shiller’s cyclically adjusted P/E for the S&P 500, represents a relative high, nearly at the high of the series record set in 2000. The parallel expression in credit markets, which is the BoAML option-adjusted high yield spread, was similarly stretched. Reading recently around 300 basis points over Treasuries, high yield credit spreads were within a few basis points of the decade lows.

Defensive positioning warranted

So, what do we make of a credit market that from an average valuation perspective, represents a potential high tide? The data suggest a more defensive positioning is warranted. Through the year we have generally been edging out of more aggressive trades. Those who follow our risk categorizations will note that we have added weight to “bucket 1” (high quality most liquid) and reduced “bucket 3” (wider spread credit opportunities).

The caveat we add here is that, just as tides in different locations are not simultaneous, valuations in different markets are not uniformly stretched. So, we continue to turn over ideas in certain sectors (biotech, travel and China-domiciled to name a few) because these are situations where it appears to us that the valuation tides are much lower. It is not that we don’t hold some dry powder for potential issues to emerge in the main North American credit market, but we are still finding some “risky” things to do in a few places where investors are paying heightened attention to risk already.

Overall, we operate in a fashion that is neither purely micro nor macro. We pay attention to the valuation tides. But whatever the sea level, we believe there is always the potential to encounter the next perfect wave.

Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – November 2021. Used with permission.

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