Avoiding credit risk in an uncertain recovery

The Federal Reserve’s intervention into the corporate bond market has artificially inflated prices, creating risks for fixed income investors, portfolio manager Ignacio Sosa says.

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Sosa, the director of international relationship management at DoubleLine Capital in Los Angeles, Calif., said about half of all investment-grade corporate debt is barely investment grade, and therefore vulnerable to downgrade in a recession.

Few companies were set up to deal with the economic shock from Covid-19, Sosa said in a May 12 interview.

The Federal Reserve responded to the pandemic by cutting interest rates to nearly zero and introducing an unprecedented corporate bond-buying program that could total US$750 billion. Those purchases include “fallen angels,” or investment-grade debt that was recently downgraded to high yield.

“We would be very cautious with investment-grade corporate debt, especially since these prices appear artificially inflated by a government program which provides very little by way of credit enhancement,” said Sosa, who manages the Renaissance Flexible Yield Fund.

The Fed program provides liquidity by ensuring there’s a buyer, but it doesn’t impact the borrowers’ underlying creditworthiness, he said, nor does it improve the underlying risk of their corporate bonds.

As a result, Sosa said he’s staying away from investment-grade corporates in favour of debt not supported by the Fed, such as securitized credit instruments.

Some analysts expect the Fed to use only a fraction of its corporate bond-buying capacity — as simply announcing its intention managed to quell volatility. As of last week, the central bank had bought less than US$3-billion-worth of ETFs invested in corporate debt since the program opened May 12, Bloomberg reported.

But the economic recovery is still very uncertain, Sosa said, and he’s avoiding a lot of interest-rate risk.

“This is really not the time to be taking on what we call duration,” Sosa said. “You don’t want to have bonds with long maturity in this environment because you simply don’t get paid for them.”

Around 30 million Americans are receiving unemployment aid due to the shutdowns in response to the global pandemic. Economies started to reopen last month, but Sosa said not to expect a V-shaped recovery.

“We don’t even see a U-shaped recovery. It’s going to be much longer,” he said.

He expects consumers to be cautious, which will force businesses to take a gradual approach to rehiring.

“Until you start seeing business go back to normal — which could take months, if not years — you’re not going to go back to the levels of employment that we had in January or February of 2020,” he said.

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