Opportunistic Credit: Expanding the Possibilities of Fixed Income

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Amid heightened investor interest in private credit alternatives, and a growing focus on active management in the credit space, Lord Abbett Partner and Portfolio Manager Adam Castle, Managing Director and Portfolio Manager Eric Kang, and Investment Strategist Andrew Fox recently gathered to discuss Lord Abbett’s Credit Opportunities strategy and the current environment for opportunistic credit.

As a reminder, the Credit Opportunities strategy focuses on identifying alpha opportunities and seeks to identify idiosyncratic investment ideas across a wide array of fixed-income sectors. Positions are built upon deep, fundamental credit research. The strategy seeks credit opportunities that may provide long-term investors the potential to earn outsized returns.

Edited excerpts of the conversation follow:

Credit Opportunities was launched in 2019 against a backdrop of explosive growth in private debt markets. For all the positive characteristics of private credit, it is not the type of asset class that an investor can pivot from quickly. Private credit is the quintessential “buy-and-hold” investment. And here’s where the evolving dynamics of various fixed-income markets come into play.

On top of the increase in private debt (left panel of Figure 1), there has been significant growth in total fixed-income assets in daily liquidity funds (i.e., U.S.-registered mutual funds including index-focused exchange-traded funds) (right panel).

Figure 1. Normal Liquidity Mechanisms Have Changed in Recent Years

Amount of private debt sold in the United States, 2011–2021 (left panel); assets under management in the Morningstar Taxable Bond Category, 2006–2021 (right panel)

Private debt market data from Prequin as of 12/31/2021. (Latest available historical data.) Fixed-income mutual fund and ETF AUM data based on open-end funds only, Morningstar Taxable Bond U.S. Category Group excluding Long Government, Intermediate Government, and Short Government categories. Data as of 12/31/2021 (most recent available).
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

And therefore, liquidity is greatly prized in that space. Why? Using the U.S. high yield bond market as one example, Figure 2 summarizes monthly flows in high yield mutual funds. You can see that the periods of large inflows can be followed by periods of substantial outflows, rather quickly.

Figure 2. Potential for Large Outflows Creates Preference for Most Liquid Bonds

Monthly net flows for open-end high yield bond funds, December 30, 2007–June 30, 2022

Source: Morningstar. High yield fund flow data based on monthly net flow, all open-end funds in the High Yield Bond category. Data as of 06/30/2022 (most recent available).

The potential for large and sudden outflows could create a preference for some investors to buy the most liquid issues available in various types of fixed income.

A Shifting Liquidity Backdrop

This growing need for liquidity was clearly apparent amid the COVID-19 induced volatility in early to mid-2020. The U.S. Federal Reserve (Fed) stepped in to provide liquidity by purchasing shorter-dated corporate debt. However, the Fed’s ability to do so in the future may be limited by its ongoing efforts to combat inflation via interest-rate hikes and other measures to tighten financial conditions.

What does all this imply for markets today? Look at Figure 3, which shows spreads on high yield bonds of different sizes and credit ratings. The left panel shows the spread differential between the smallest versus largest BB-rated issuers. On the right, we see the spread differential between the smallest versus largest B-rated issuers.

Figure 3. Liquidity Differences May Create Opportunities Within the Market

Spread differential between smallest quartile and largest quartile issuers within the indicated index, December 30, 2011–April 1, 2022

Source: ICE Data Indices, LLC as of 04/01/2022 (latest available). Spread differential indicates the difference between the smallest quartile and largest quartile of issuers in the ICE BofA U.S. High Yield Index. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

We're looking at the smallest issuers on an option-adjusted spread basis minus the largest issuers, so essentially, there is a significant pick-up in yield for going smaller within the same credit-rating category. There's a liquidity premium that can be captured.

What we think is more interesting than just monetizing that premium is the variability of that line over the period covered by the chart, which illustrates that liquidity is priced differently at different times.

Of course, there's always some sort of excitement going on in markets. While credit markets had been relatively healthy since the 2008–09 global financial crisis, there have been several periods of stress in specific sectors. Figure 4 shows events that unfolded over the years that caused market stress, but also created opportunities for a flexible, multi-sector approach to take advantage of mispricings and mitigate risk.

Figure 4. Episodes of Post-GFC Crisis Market Volatility Provide Potential Opportunities Within Market Sectors Under Stress

Source: Lord Abbett. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

So, the bottom line here is that liquidity is priced differently in different times in different markets and sectors. And, in our view, the best way to attack that trend is from a multi-sector perspective. The Credit Opportunities strategy has the flexibility to draw on a range of credit sectors, including those that are less liquid than traditional fixed-income segments (see Figure 5).

Figure 5. The Lord Abbett Credit Opportunities Strategy Invests Across Multiple Fixed-Income Sectors

Source: Lord Abbett. CLO is a collateralized loan obligation. ABS is an asset-backed security. MBS is a mortgage-backed security. Please see sector definitions in the disclosure.

The widened scope of the strategy provides the investment team with multiple asset classes from which they can source potential investment ideas and take advantage of sporadic episodes of volatility. Diversification may also mitigate a fair portion of the risk during periods of reduced market liquidity and give our team a better chance at maneuvering through dislocations in select credit sectors. (Of course, diversification cannot guarantee a profit or protect against losses in a declining market.) The upshot: We believe there are significant opportunities to capture liquidity premiums in the less-liquid segments of the credit markets. But rather than simply loading up on disfavored sectors hoping for a snapback, we seek to identify specific securities that fit our criteria. We are looking for those “dislocated” issues that we believe offer (1) attractive return potential and (2) idiosyncratic drivers unrecognized or underappreciated by the broader market that will enable us to capture alpha opportunities.

Exploring Strong Conviction-Based Ideas in Opportunistic Credit

Credit Opportunities is a benchmark-agnostic strategy that focuses purely on the convictions of the investment team. The strategy is currently composed of approximately 70-110 investment ideas, leveraging a 50 year-plus multi-sector heritage that really is at the heart of how we approach all credit investing at Lord Abbett.

The investment team’s security valuation discipline—which identifies the most compelling investment candidates—is backed by deep fundamental research, and that multi-sector approach helps us to “skate to where the puck is going” instead of waiting for opportunity to come to us in a specific asset class. And going just a little deeper, we combine that deep fundamental research with scenario analysis; our professionals assess the probable outcomes to help shape our investment decisions.

This is important, because, on offense, it helps us think about upside potential. But, importantly, from a risk management perspective, it sets some mileposts and discipline for exiting positions either if probabilities move against us or fundamentals change.

This construct is essential as we think about how to take advantage of difficult markets. Using the example of 2020, we were able to allocate and rotate capital across different sectors because we had these disciplines in place. We were ready to rotate our portfolio and redeploy capital multiple times as the U.S. economy came out of the depths of the COVID-19 crisis.

We've combined all these capabilities into one strategy with a fund structure that really allows us to focus on those investment ideas with high potential, but which may need a longer horizon to realize value.

Looking Ahead

As we look ahead in 2023, we note that tighter financial conditions in the United States may force banks to sell high-quality assets, and this forced selling is likely to be done via the securitization method. We believe this will also create an opportunity for our strategy, deploying a multi-disciplinary attack using the credit analysis that we perform with our global credit research team.

We will be focused on idiosyncratic selection, mis-rated credits, and securities of issuers that need some time for fundamentals to play through and for valuations to catch up—those situations that offer total return optionality.

One thing we're certain of is that the liquidity-providing mechanism at traditional intermediaries (banks, et al.) is irrevocably changed. That is likely to result in more and more moments of volatility. And, given our strategy’s structure, and our capability set, what we know is that these moments of volatility won't always hit the same asset classes. So, having that multi-sector construct in place, having the rigorous analytical capabilities at our disposal, and having the right investment vehicle to encapsulate them offers what we think is an exciting opportunity in the fixed-income space.

Related Funds

LARAX

Class A

Credit Opportunities Fund

$8.33

as of 04/30/2025

$0.06

Fact Sheet

Insight

A Renewed Focus on Intermediate-Term Bonds

With starting yields higher than they have been in more than a decade, core bonds present an appealing opportunity for current income and long-term total return.

About the Contributors

Adam C. Castle, CFA

Partner, Portfolio Manager

Eric P. Kang

Partner, Portfolio Manager

Andrew Fox, CFA

Investment Strategist

Important Information

NOT FDIC INSURED–NO BANK GUARANTEE–MAY LOSE VALUE

The Lord Abbett Credit Opportunities Fund is structured as an unlisted closed-end interval fund. Limited liquidity is provided to shareholders only through the Fund’s quarterly offers to repurchase between 5% and 25% of its outstanding shares at net asset value, subject to applicable law and approval of the Board of Trustees. The Fund currently expects to offer to repurchase 5% of outstanding shares per quarter. There is no secondary market for the Fund’s shares, and none is expected to develop. There is no guarantee that an investor will be able to tender all or any of their requested Fund shares in a periodic repurchase offer. Investors should consider shares of the Fund to be an illiquid investment.

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A Note about Risk: The Fund is subject to the general risks associated with investing in debt securities, including market, credit, liquidity, and interest rate risk. The Fund may invest in high yield, lower-rated securities, sometimes called junk bonds. These securities carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. The Fund may invest in debt securities of stressed and distressed issuers as well as in defaulted securities and debtor-in-possession financings, all of which may be considered Special Situations. Distressed and defaulted instruments generally present the same risks as investment in below-investment-grade instruments. However, in most cases, these risks are of a greater magnitude because of the uncertainties of investing in an issuer undergoing financial distress. The Fund may invest in foreign or emerging market securities, which may be adversely affected by economic, political, or regulatory factors and subject to currency volatility and greater liquidity risk. The Fund may invest in derivatives, which are subject to greater liquidity, leverage, and counterparty risk. These factors can affect Fund performance.

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Glossary & Index Definitions

Bank Loans or Leveraged Loans are loans extended to companies or individuals that already have considerable amounts of debt. Lenders consider leveraged loans to carry a higher risk of default and, as a result, a leveraged loan is more costly to the borrower.

Convertible bond is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features.

Collateral Loan Obligation (CLO) is a special purpose vehicle (SPV) with securitization payments in the form of different tranches. Financial institutions back this security with receivables from loans. Collateralized loan obligations are the same as collateralized mortgage obligations (CMOs) except for the assets securing the obligation. CLOs allow banks to reduce regulatory capital requirements by selling large portions of their commercial loan portfolios to international markets, reducing the risks associated with lending.

Asset-Backed Security (ABS) is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities. For investors, asset-backed securities are an alternative to investing in corporate debt.

Commercial Mortgage-Backed Security (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property. A CMBS can provide liquidity to real estate investors and to commercial lenders. As with other types of MBS, the increased use of CMBS can be attributable to the rapid rise in real estate prices over the years.

The Federal Reserve System (Fed) is the central bank of the United States and is governed by the Federal Reserve Board. The Federal Open Market Committee (FOMC), the policy-setting arm of the U.S. Federal Reserve, issues projections of the rate of U.S. economic growth at the conclusion of its meetings in March, June, September, and December of each year.

The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.

A liquidity premium compensates investors for investing in securities with low liquidity. Liquidity refers to how easily an investment can be sold for cash. Liquidity premiums, which are the cost of daily liquidity in the form of lower compensation, or yield, for similar credit risks.

Opportunistic credit investments seek to capitalize on dislocations in credit markets and mispricings that can occur in fixed-income markets.

Private credit covers an array of strategies that span the capital structure and borrower type. These range from senior secured loans for blue-chip corporate borrowers, to junior unsecured credit for financing new building construction, to loans against specialized assets such as railcars and airplanes or contractual revenue streams like royalties and subscription services, to distressed situations.

Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield-to-maturity (YTM) represents the expected return (expressed as an annualized rate) from the bond’s future cash flows, including coupon payments over the life of the bond and the bond’s principal value received at maturity. Yield-to-worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. One such comparison involves the two-year and 10-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

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