Know your credit. Score

The catch-all term “credit” offers insight similar to “thing” or “stuff”. Most things and stuff have vagaries, nuance, and differentiation - and so does credit. This is an important time for investors to appreciate the distinctions within credit investing.

Many recognize that credit refers to borrowed money, like a bond, loan, or mortgage, although often with as much clarity as saying restaurant when referring to McDonalds, The Keg, or Noma.

Within credit investing, the following descriptors tend to help frame the topic: government bonds, corporate bonds, high yield bonds, bank loans, mortgages, private debt - to name a few. Each of these categories offers some insight into the nature of the credit investment, including elements like credit quality, structure, and liquidity - leading to a notion of riskiness and yield. To be clear, every credit investment has a price, but we refer to it as a yield since that is its expected payout if all goes as planned. Yields also allow for more straightforward relative value comparisons among credit investments. 

The catch-all term credit does correctly infer that the valuation of most or all of these investments are inter-related, in that there is a relative value amongst them. Those values, however, are affected by varying factors, to varying degrees, and importantly with very different immediacy. Some instruments are re-priced by the minute while others only quarterly, or even less often, or simply held at cost. 

There is a risk continuum within credit, reflecting the credit quality of the borrower, likelihood of timely payment, expected volatility, and illiquidity - creating material differences in each subset as a suitable investment solution. 

Credit spreads - the amount the borrower pays above a government benchmark, have different reaction functions and different reaction timing to market, economic, political, and idiosyncratic news. Some react with greater sensitivity because they are riskier and more volatile, while others react less because the same news isn’t sufficient to question the borrower's likelihood of timely payment. Some are structured to be repriced on a lagged basis, as private credit funds are, offering little insight into ongoing quality from regular updates. Further, credit spreads tend to move in the same direction, tighter (better) or wider (worse), albeit with these varying magnitudes and timeliness. Credit spread movements provide important signals for other credit instruments, and for other asset classes.

That is where this starts to get interesting - the signals offered by moves in credit spreads or yields, or by their lack of movement.

One important detail to focus on is the currently expensive, low credit spread, and low yield of high yield / below investment grade bonds.  High yield bonds have a greater correlation to equity markets due to the factors that cause their current yield to change, recognizing that they are on the risker end of the credit spectrum. The yield of high yield bonds is low compared to their long-term average and range, supported by; better corporate credit metrics, enormous demand for yield and by income investments, and massive flows into fixed income funds over the past two years.

Yields and yield movements of high yield bonds provide an important signal to other credit instruments, and also to other asset classes. The equity outlook is buoyed by the all-clear signal that currently tame high yield offers, perhaps mistakenly. Relative value pricing of investment grade credit, bank loans, and private debt are also encouraged lower by currently low and stubborn yields for these below investment grade bonds. 

Technical factors, like demand versus supply, the modest total size of the public high yield bond market, demand for yield, and corporate credit fundamentals are keeping high yield rich while economic and political turmoil reigns. Some argue that the growth of the private credit market has artificially tightened the credit spreads of now more scarce public high yield bonds. The trick is to differentiate between the technical and fundamental factors to read the signals that high yield offers, and to consider the likelihood that those yields stay this low, and payoff as expected.

The private credit market is the second interesting credit topic. The massive growth in demand from both private borrowers and lenders/investors has taken supply away from the high yield and bank loan markets. The fact that underwriting standards have inevitably been lowered by some underwriters / investors to meet the asset management opportunity from increased demand - leading to questionable credit quality, and that private funds are typically opaque, and that private loans and loan funds are only revalued quarterly or less frequently while other asset values are falling, are all reasons for current concern for some private debt funds. 

Some private credit funds are based on a held-at-cost model, or other methods that price infrequently, inferring an unreal sense of low volatility. I would argue that, mistakenly, some see the lack of regular repricing as a benefit of the asset class, because on paper they do act less volatile - even if they are not. Do you think private credit is equally valuable now as it was before high yield recently started shifting wider, as bankruptcies have spiked, and as equities approach correction territory?

“Private credit’s meteoric rise over the last 15 years has created excess—and 2025 may be the year we see how well firms have underwritten through it.” Robert O’Leary, Co-CEO, Oaktree Capital Management, L.P.

This “stuff” is indeed inter-related, but “credit” is far from uniform. One type of credit will affect the pricing and attractiveness of the other, but the key is to understand the nature of each subset and its nuance, and to choose the type of credit that suits your portfolio needs best. It depends upon the investors desire and capacity for risk, and the accurate calculation of the effect on total portfolio risk when adding riskier credit.  

For example, investment grade credit has demonstrated behaviour that suits almost any portfolio’s fixed income allocation. Even though investment grade credit spreads are tighter than they were, some funds are producing running yields of 6+% from less risky exposure to high quality, short-term, Canadian, public corporate bonds. Noting that short-term Canadian credit is more compelling than similar term US credit. Further, some high yield and some private debt, in the right amounts and from the proven managers, may still fit in some fixed income portfolios too. Mortgages are a good example of a secured investment that when underwritten properly are a more defensive form of private credit. However, some high yield and private debt funds should be avoided today, or at a minimum require an allocation from the total portfolio risk budget and may be more suitable for the equity or absolute return part of a portfolio.

Currently, some high yield and some private debt are arguably too uncertain due to how historically expensive they are, questionable and often opaque credit quality, illiquidity, undependable lagged valuation, and historically high correlation to very volatile equities. High yield and private debt may be too uncertain or too richly priced to meet the hurdle for prudent investment in an optimal fixed income allocation.

Be very careful what you surmise from the calm that you think you see and what you hear about in the riskier part of the credit spectrum today. The fact that high yield bonds remain rich and the fact that the lagged prices of private debt funds remain sanguine does not mean that it will stay that way or that they provide an all-clear signal for other credit or for other asset classes. If and when high yield and private debt recognize the ongoing political and economic turmoil their rich prices and deteriorated underwriting standards have left them with limited capacity to handle bad news.

Proven, defensive private debt funds and investment grade credit funds likely offer the expected return and the resiliency that today's fixed income investment demands.

Kevin Foley is a Managing Director, Institutional Clients at YTM Capital. YTM Capital is a Canadian asset management company focused on “better fixed income solutions” specializing in Credit and Mortgage funds. Kevin is the former Head of Credit Trading, Sales and Research at a major Canadian bank, and he sits on three Canadian Foundation Boards and Investment Committees.