May 2023 / INVESTMENT INSIGHTS
Smoothing the Ride for Credit Allocations
Dynamic Credit Strategy offers a flexible, differentiated approach
- The Dynamic Credit Strategy is well suited for those who want to take advantage of credit opportunities while also seeking a “smoother ride.”
- The strategy focuses on credit selection and sector rotation to generate alpha, coupled with active duration and credit beta management..
- The composite within the Dynamic Credit Strategy posted a nearly flat return in 2022, demonstrating the value of its approach in a historically difficult year for credit markets.
The Dynamic Credit Strategy seeks to offer investors a “smoother ride” in credit investing by finding diverse alpha1 sources in a variety of market environments. The strategy focuses on credit selection and sector rotation across the credit spectrum—high yield, investment grade, emerging markets, securitized, distressed, municipals, convertibles, and bank loans—of the global multi‑asset credit (MAC) universe.
The strategy harnesses expertise across T. Rowe Price’s global multi-sector research platform to deliver an actively managed, flexible portfolio with a long2 bias. Coupled with this long bias, which is expected to deliver 80% of the strategy’s returns, we employ active credit shorting3 and duration4 management in looking to add further alpha and dampen volatility. Our strong emphasis on finding credit dislocations, our total return perspective, and our goal of creating a differentiated portfolio are embedded in the design and the process of the strategy.
Key Source of Differentiated Returns
In addition to the strategy’s goal of delivering alpha across the broad credit market, we also strive to limit undue credit beta and duration risk. We believe that our approach to portfolio construction makes the strategy a compelling and consistent credit allocation, and its differentiated returns also enable it to complement other credit allocations. The strategy’s lower credit beta profile should allow it to hold up well in environments where credit spreads5 are widening, while its lower duration profile should be a positive in rising interest rate environments.
Credit Exposure: Creating a Better Way
(Fig. 1) Strategy strives for more flexible, alpha-oriented outcomes
Spotlight on Credit Research
The strategy’s repeatable process relies heavily on our global research platform of more than 300 people, who collaborate across investment strategies, asset classes, and geographies. Our team of credit analysts integrates proprietary environmental, social, and governance (ESG) factors as appropriate into the analysis. The table below provides examples of typical types of positions:
Three Primary Credit Evaluation Factors
When collaborating with our credit sector experts and evaluating individual credits for potential portfolio inclusion as either long or short positions, we ask three key questions:
- Is there a catalyst that could cause the credit to outperform? Depending on the type of credit, this could be a range of factors, such as a potential credit rating upgrade or downgrade for a corporate credit. For consumer‑dependent credit like an asset-backed security (ABS) backed by auto loans, it could be an upturn in consumer payment trends.
- Is the position positively or negatively correlated7 with the performance of existing portfolio holdings? A meaningful negative correlation could indicate that the new position can provide diversification benefits by gaining when other exposures lose value.
- What is the asymmetry of the return profile? Essentially, will the price benefit more from a positive development than it suffers from a negative outcome—or vice versa? This can affect how a holding would fit into the strategy’s overall positioning in terms of sizing, diversification, and potential alpha generation.
Performing as Expected
(Fig. 2) Dynamic Credit Fund held up in volatile 2022
In addition to addressing these three factors, our investment process tries to ensure that we are getting paid for each position’s embedded credit beta,8 volatility, and liquidity. Our dynamic, flexible, and alpha-oriented approach has enabled the composite to deliver differentiated performance in challenging markets such as in 2022, when traditional credit sectors suffered amid rapidly rising rates.
Approach Well Suited for Unsettled Credit Environment
The strategy’s alpha-seeking but risk‑aware approach is well suited for a range of market conditions, but it may be even more valuable in the current unsettled credit environment. We believe that our fundamental credit analysis process that generates forward-looking insights from a global research platform with broad sector expertise can help the strategy identify and capitalize on inefficiencies ahead of the market.
What We’re Watching Next
We have recently observed that banks are tightening their lending standards, which typically precedes the end of a credit cycle and rising defaults by two to three quarters. This changing environment may produce opportunities across the range of credit markets.
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