Diversify with alternative credit

Lower-rated credit delivered strong performance last year, with a 12.8% total return for US high yield (using ICE BofA US HIgh Yield Index data). But widening dispersion between stronger and weaker borrowers in the year ahead may increase the appeal of credit arbitrage strategies as part of a well-diversified portfolio.

While we expect benchmark interest rates and bond yields to follow growth lower in 2024, we think credit spreads, default rates, and credit losses could rise more for financially vulnerable companies, especially those with upcoming debt maturities. This will likely lead to more long- and short-trading opportunities. Dispersion stands higher than long-term averages, presenting potential opportunities for discerning managers to make single-name credit choices based on fundamental analysis.

There are risks to consider when investing in this strategy, including illiquidity, lower transparency than public markets, and the risk of near-term losses when companies first become distressed. Risk management, including the use of index portfolio hedges to reduce market exposure, is key.

We also see good strategic opportunities in distressed and special situation funds. Lagged effects of higher interest rates could put pressure on companies’ ability to refinance. This should provide a consistent source of deal flow for distressed and special situation funds. The distressed opportunity is likely to be focused in areas of the market that have already seen some dislocation, such as properties facing bankruptcy or tenant distress. In other sectors, distressed funds could find opportunities in overly indebted businesses that struggle to cover interest costs.