Commodity Watch: What to do when its tight…

<div class="grid grid--33-66-col"><div class="col"><img loading="lazy" data-fr-image-pasted="true" src="/getContentAsset/e4db1c4c-2687-44cd-adbd-db1eb849e5d2/cb87803a-320c-480f-ab75-7b9029eaaf79/Ahmad-Al-Sati-new.jpg?language=en" alt="Ahmad Al Sati" title="Ahmad Al Sati" class="fr-fic fr-dii" style="width: 180px"></div><span style="font-size: 12px"><div class="col"><strong>AHMAD AL-SATI<br></strong>PORTFOLIO MANAGER<br><br><p>Ahmad is the President and portfolio manager for Gemcorp Capital Advisors LLC, based in New York.&nbsp;<br><br>Ahmad has spent most of his career in the global credit markets. Prior to Gemcorp, Ahmad was President of Pandion Mine Finance and RiverMet Resource Capital, LP - a fund focused on investing in precious metals, where he was responsible for managing the investments and the day-to-day operations of the registered investment adviser.&nbsp;</p></div></span></div><hr><p>You know it’s tight out there for a bond investor. The Bloomberg High Yield Index Option Adjusted Spread (OAS) over U.S. Treasuries has been at historic lows and decreased further on Friday. It is now 45 bps above the 30-year low for this index (reached in 2007) and is below the daily average for this year. These tighter spreads permeate the entire fixed income asset class and are not confined to one corner or another, creating challenges for bond investors globally.</p><p>Lower spreads are not necessarily a harbinger of bad things. These conditions can persist without any major crisis, especially if the technical and fundamental conditions for them exist and continue. Favorable macroeconomic conditions (per current market expectations), fiscal stimulus (continued tax cuts), lower default environment (thank you liability management), increased demand for bonds and lower bond supplies (as borrowers seek private bilateral credit relationships) all could support narrower spreads.</p><p>Yet, the risks are to the downside. Tighter credit spreads mean that bonds are more likely to correlate to equities if a crisis or hiccup materializes – spreads could widen as equities go down. Narrower spreads also mean that bond prices cannot increase much from here lowering potential total returns unless spreads tighten more (unlikely). At the same time, investors are not being paid much above US government bonds. The bond portion of the 60-40 portfolio today is thus less effective (more correlation and downside risk) and less attractive (lower income and lower total return potential).</p><p>What is an allocator to do?</p><p>They can wait (hope?) for a better entry point, increase duration, invest in lower quality bonds or forgo liquidity. That is, chase yield. Or they may seek to manufacture yield and return through private and structured credit transactions. The increase in demand for private credit by allocators and investors is telling. But as basic private credit in the US and Europe becomes increasingly crowded and PE transactions (a driver of private credit) are taking longer to consummate, private credit writ large might begin to suffer diminishing returns and lower liquidity. Increased competition for a lower number of deals means that private credit funds are competing with each other for the same borrower and thereby compressing pricing and loosening covenants - not usually good for lenders.&nbsp;</p><p>Complementing basic private credit allocations with credit strategies that are (i) decoupled from the capital markets, (ii) less dependent on financial engineering, and (iii) exhibit resilience even in downturns should help enhance portfolio and provide insurance against a credit downturn. We have health insurance, house insurance and car insurance. We might as well add portfolio insurance.</p>