Compelling Opportunity for Investors: Improving Convexity, Yet Benign Default Risk
(Adviser & Wholesale Investors Only)
Ares Australia Management
28 June 2022
What is Convexity & Why Is It Important?
When credit instruments sell off, market participants will often talk about convexity being back. So, what is it?
During a risk-off environment, the price of a credit instrument typically drops below its nominal value (also referred to as "face" or "par" value) due to perceived increased default risk. As illustrated by the example in Chart 1 below, there is a compelling investment opportunity when a bond trades at a discount to its nominal value - assuming the bond does not default, a bond's price will benefit from a natural "pull" to the nominal value as it approaches maturity. This movement is referred to as "pull-to-par". Typically, bonds and loans that trade at a discount have positive convexity, offering investors enhanced yield and capital appreciation potential without taking excess risk.
Market Opportunity - Convexity & Higher Yields
Calendar year 2022 has presented significant turmoil for global financial markets amid a risk-off environment and sustained macro uncertainty. Global inflationary pressures continue to persist, including the ongoing war in Ukraine, slowing growth, higher energy prices and supply-chain disruptions. Central banks face substantial challenges as they look to combat elevated inflation with interest rate hikes, but without triggering a recession. Against the backdrop of wider spreads and the sell-off in rates over the past few months, fixed income yields have reset to higher levels, presenting an attractive opportunity for yield-focused investors. Global leveraged credit assets are providing a meaningful pickup in real yields when compared to traditional fixed income markets, as illustrated in Chart 2.
Higher yields and a decline in asset prices have introduced greater upside convexity in leveraged credit
This combination of higher yields and cheaper prices in an environment where bouts of volatility have become shorter and more frequent, is presenting alpha generating opportunities for active managers. History suggests investing in periods of dislocation, when yields reach current levels, provides attractive forward returns in the high yield bond and bank loan markets.
Looking forward, we expect volatility to persist with the potential for asset coverage leakage and an uneven recovery across markets. We believe credit spreads are currently at levels that represent attractive entry points, but tail risks have increased, and we anticipate elevated credit dispersion as well as rising idiosyncratic credit events driven by a host of conflicting themes. We believe Ares is well positioned to provide superior credit selection and vigilant risk management in today's volatile market due to our disciplined investment process that focuses on capital preservation, predicated on bottom-up fundamental research with the goal of minimizing default risk by identifying and avoiding marginal quality credit. This core tenet of Ares' investment philosophy has resulted in significantly lower defaults in its bank loan and high yield bond strategies, particularly in periods of dislocation.
In summary, as investors are faced with rising rates and elevated inflation, many may struggle to determine how best to position their credit exposure in an effort to maximize yield and mitigate risk. At Ares, our differentiated approach to capitalizing on the best risk-adjusted return opportunities across the investable universe is rooted in the scale and integration of our Global Liquid and Alternative Credit strategies, which allows us to fully leverage extensive research and origination capabilities, proprietary technologies and longstanding relationships.
Written By Teiki Benveniste, Head of Ares Australia Management
Funds operated by this manager:Ares Diversified Credit Fund, Ares Global Credit Income Fund