The more things change, the more they stay the same. Outside of the largely duration-driven (for now) investment grade fixed income markets, the environment for credit and credit alternatives remains attractive, albeit complex. (i.e., return exceeding the risk-free rate). For traditional high yield and bank loans, the strength of corporate profits and resiliency of the economy anchors a favorable fundamental outlook. If 2025 mirrors 2024 in that the health of the economy remains the prevailing driver of returns in credit, investors should achieve the targeted excess yield in these non-investment grade securities.
Hunting for Alpha in a Changing Landscape for Credit
However, as other Pathstone colleagues discuss in our 2025 Investment Outlook, there are a myriad of macro and micro elements that create risk. For example, tight credit spreads in the face of higher rates suggest economic strength is priced in. Additionally, persistent interest rate volatility creates a more challenging setup for corporate and real estate refinancing — stability of which is a hallmark of durable credit markets. Finally, the weakening credit quality of the U.S. driven by continued deficit spending and reflected by rising term premium creates opaque systemic risk on a global scale, in particular for interest rate, currency and commodity markets.
While impossible to time the appearance of these elements or predict the magnitude, their potential for significant impact creates asymmetric risk/reward for traditional credit and perhaps even investment grade securities. Unlike investment grade securities, credit historically does not provide portfolio insurance against a drawdown in riskier assets like equities. In times of high valuation and uncertain direction of interest rates, alternatives to credit or diversifying, less correlated strategies could have an important role in portfolios. Examples of these strategies include fixed income and credit relative value, global macro trading, and convertible and capital structure arbitrage. Such investment approaches are particularly attractive in periods of high security dispersion and relatively inexpensive hedging, both of which persist currently. The goal of a well-diversified pool of credit alternatives is to deliver returns akin to high yield debt but with the volatility characteristics of secure investment grade debt.
To explore these themes in more detail, please see our recent Credit Review & Outlook: Hunting for Alpha in a Changing Landscape, in which colleagues Chris Martin and Emily Amland describe the opportunity for active management in credit and the potential for attractive risk-adjusted return using a diversified approach.
