I recently had the privilege to interview Steve Boothe from T. Rowe Price about investment grade (IG) credit. I had heard him speak at the Jana Investment conference a few years earlier and his presentation was excellent.
EM – Welcome Steve, can you please tell me a bit about your role as Head of Investment Grade Credit at T. Rowe Price and how long you’ve been in IG credit?
SB – Sure. So, I currently run global investment grade at T. Rowe Price. So, what does that mean? All of the investment grade credit strategies, including securitised products, all of the Portfolio Managers (PMs) that run those strategies report to me. Also, the US investment grade multi-sector business, so think core, core plus, all of those PMs report to me as well.
It’s 12 direct reports. My team is responsible for about US$70 to 75 billion of T. Rowe Price’s US$360 billion in fixed income assets. I also serve as a portfolio manager on the global credit strategies, the US credit strategies, and also on our absolute return strategies as well. So, I run a number of both benchmark-oriented strategies and cash plus benchmark-oriented strategies and a lot of things in between. Our insurance capability rolls up to me as well.
I’ve been with the firm for 25 years and I’ve been in investment grade credit my entire career. I started as a junior analyst, associate analyst, was an analyst covering the TMT sector in the early 2000s. So, a lot of what we’re seeing right now looks and feels very familiar to me as a former technology analyst. I became a portfolio manager around 2013 and then started running the business that I currently run five years ago.
EM – You’ve got so much experience, and you talked about technology and starting in technology and it’s come around again. Do you want to talk a little bit about that, what you’ve seen, what’s changed in 25 years, what’s not changed in 25 years?
SB – Well, so what’s not changed is actually fairly easy. Underwriting credit is still credit. We are sort of thinking about it in options terms. It is a put option on firm assets and that doesn’t change whether it’s investment grade credit, high yield credit, whether it’s private credit. I know there’s a view out there that private credit is some sort of magical infinite information ratio product. It is not. We’re underwriting the same optionality, regardless if it’s private, public, high yield or investment grade. So, that absolutely has not changed. I would say what really has changed, and I think most people kind of separate their careers between pre-GFC and then post-GFC. I actually think there’s been a ton of change within the last five years relative to that post-GFC up until about five years ago period. That immediate post-GFC period, economies in general, but the US economy specifically was in a deleveraging cycle.
We were just taking credit risk out of markets and we would occasionally have our troubled periods, such as the European debt crisis, the energy crisis. But, by and large, that was a window of where balance sheets were generally deleveraging, consumer credit was improving, and corporate credit was pretty benign. And then you had an activist central bank policy that was just really taking a lot of volatility out of markets in general.
That’s radically changed over the last five years because of the inflationary dynamics. Also, we’ve migrated from a world of activist Fed policy to activist fiscal policy. Fiscal authorities have been much more aggressive in this post-COVID period. So, that’s certainly been a pretty big change. But I think some of the more interesting changes and maybe even tying it back to my presentation at the Jana conference several years ago is just who buys credit and who owns credit?
The biggest difference there, the most radical change is the buyer base has been passive. The index products, the index managers, the passive managers have just continued to take market share from active managers. It’s been an accelerating trend in the equity market. I think in the equity market, we’re roughly 60% or so passive relative to active. That’s happening in credit as well. So, as those products, as that framework increasingly penetrates the market, you have more ETF issues, you have more indexation happen, that will just increasingly change how risk is priced and go back to my original observation of underwriting credit is really just underwriting a put option. If increasingly the marginal buyer doesn’t treat the asset class as if you’re underwriting an option, if it just buys whatever’s put in front of it, that changes the market. And I think that change remains underappreciated.
I think the other big change, particularly if I date my career from the early 2000s to today is obviously the technology of how we trade.
Right now, trading risk has migrated from a partner with a dealer to move a block of risk to now we’re partnering with an algorithm and trading blocks of risk as portfolios as opposed to single name. That’s a pretty significant difference in market structure as well. It’s highly correlated to passive.
The portfolio trading ecosystem, the electronic ecosystem doesn’t really exist without the passive ecosystem, without the ETF ecosystem. Just think about how the ETF products are used to hedge books. If the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE:LQD) doesn’t exist, it becomes a lot harder to do those portfolio trades because you don’t have an outlet for risk, you’ll still have an instrument to hedge your book. So, I’d say those are probably the big evolutions that I think are important over the last five, 10, 20 years.
EM – Sticking with that theme where do you think the market might go in the next five or 10 years? What might you see or predict in coming years?
SB – I do think technology will continue to make trading more efficient, make us price risk more quickly, more efficiently. I think there’s going to be a much greater connection between the time that I have a flow or have capital put to work to where it’s finally going. That time is shrinking and I think will continue to shrink. So, I think technology will make trading, moving and deploying risk, that time the market, will continue to shrink. I do think the ETF ecosystem, particularly within fixed income will continue to grow. It’ll probably grow at a similar pace, maybe even faster over the next several years. And while I think active will play a much bigger role in the fixed income ETF ecosystem relative to the equity market, the reality is that I do think that passive framework will continue to take market share over time.
And if you think about it, we’re in the really early stages of a very massive CapEx cycle. If you think about the current weighting of the hyperscalers within the investment grade market, they’re currently around 3%, that’ll likely double over the next couple of years and passive will play a role in that. They’ll be forced to allocate capital into the issuers that are growing as a percentage of the index and that will ultimately contribute to pricing that risk and potentially lead to mispricing.
EM – That was my next question. Can that passive markets accurately price the risk of those AI bonds if they continue to take greater market share? Obviously, you think risk could be mispriced?
SB – Yes, there are a couple of things there. The credit quality of the hyperscalers, is around AA to single A credits. Under some more stressed scenarios, at worst will be single A and BBB, so, we’re not worried about the excess over leveraging risk that we saw with the energy cycle in 2015 or ‘16. So, really what we’re just talking about is a degradation in ratings and the market just absorbing an increasing amount of debt. So, that becomes more of a technical concern than a fundamental concern for hyperscalers specifically. What is interesting is, an increasing amount of capital being deployed to fund the build out is being done in the 144A market and it’s a sort of semi-private market in the US.
They’re not index eligible. And so, when you think about some of the data centre deals that have been announced throughout this year, both Meta transactions, Google did one, Nvidia did one. These are structures, that really sit in that grey area between corporate credit and asset backed securities. They have a corporate linkage to it. Usually, you have some form of guarantee from Meta or from Google, but they are amortising structures. So, they do deleverage over time. So, they look a little bit like an ABS security, but they have a corporate tilt to them. Approximately US$50 billion or so has been issued in this particular market, year to date. I think that’s going to grow and grow rapidly, but this will all sit outside of the index unless they change the index rules. So, I think it’ll be interesting to watch the dynamic between the index providers, investors and issuance.
If this asset class becomes big enough, say a US$150 billion asset class, which I think it could be, will it eventually be included in the index? That becomes an interesting idea because these are pretty attractive bonds right now that we’re growing this asset class and there’s a little bit of speculation involved. Like, what’s the ROI going to be on Meta’s CapEx? But if these bonds are eventually included into an index that’s going to provide an automatic bid to them, this will add proof to the whole passive thesis, right? If those bonds are included in the index and they automatically tighten 25 or 50 basis points or whatever it is, that will immediately tell you that passive is clearly impacting the price of markets.
EM – Is the IG market expensive? Also, are you seeing any impact from rising sovereign yields?
SB- So, spreads, are certainly tight but within historical ranges. You’re not really going to make an overly compelling spread valuation argument for credit. Unfortunately, this is just how credit behaves. Credit tends to spend most of its time at the tight end of its ranges, and then we have a moment and we reprice quite aggressively. We start to mean revert again. I think that also makes today’s market a little more unique versus history, and I’m sure you’ve heard this before, is the all-in yield. It’s now a yield product. Investment grade is as much of a yield product as it is a spread product. So, when you marry that 80 basis points or so of average spread plus current all-in yields, you can earn high 5%, 6% nominally without taking a lot of credit risk, without moving down into high yield credit with an investment grade product.
That’s pretty attractive. As long as that dynamic remains in place and that relative value and yield remains in place, flows are going to remain positive and the asset class will remain priced as it is. You need to think about your relative value framework it in two ways. Versus history, absolutely. The spreads don’t look all that attractive. But if you think about the go forward environment, we’re in an environment of pretty robust nominal GDP. We’re in an environment where corporate profits are at all time highs, margins are very robust. Despite all of the CapEx that we’ve seen in the technology sector and the re-leveraging of that sector, average corporates have actually delevered. So, credit fundamentals remain just rock solid. If you think about spreads relative to fundamentals and relative to the macro environment, suddenly they start to look more fairly priced.
And I think we’re going to be in this environment for an extended period. You always have to give the caveat if there’s an exogenous shock because they’re always going to be. But from the market itself, there’s currently not really major sector imbalances. There’s not a particular sector that is overextended itself in credit. There is a sector that is rapidly growing as percent of the market, that’s technology and that could become a problem five, six years from now. But where we are today, I think maybe the more nuanced answer is that spreads are pretty fairly priced relative to the current fundamental environment and where we think the overall economies are going.
It’s difficult to draw a straight line between the shift higher in treasury yields and the treasury curve and connect that to credit spreads. If anything, it’s been a net positive because it’s improved all the yield profile and improved the forward total return profile. Now where we do see some frictions, and I think you can draw a bit of a line to the treasury market, has been in the long end of the IG curve where there’s been a lot of duration issued. And this goes back to the hyperscaler point.
The hyperscalers have issued an enormous amount of paper this year and about a third of it has been 10 years or longer. And the market has struggled a little bit to absorb that much duration, very similar to how the treasury market has struggled a little bit to absorb the amount of duration that it’s taken on this year as well.
So, there’s a linkage there. There’s certainly a correlation, but I think the correlation is really the amount of duration the overall private sector is being asked to take on, particularly relative to your historic duration. So, US pensions have less demand for duration. Insurance companies have less demand and are buying private credit or other assets. Japanese lifers are buying less duration. So, there’s just a little bit of a supply and demand imbalance in the long end of the curve. I think that’s in the process of getting it cleaned up. I think as we move forward to the rest of the year and into next year, it’s going to be less of an issue.
EM – In terms of asset backed securities versus outright bonds versus other sorts of securities, do you have any preference?
SB – When we think about our portfolios now, we do like taking risk in the front of the curve and the securitized credit market, particularly within ABS and particularly within CLOs. We think you’re getting a yield and spread pickup. We don’t think you’re taking on incremental credit risk. In fact, in many cases, you’re taking on less credit risk, and you have very attractive deleveraging properties or very attractive roll down, particularly relative to short-dated investment grade credit. You can pick up 40, 50, sometimes 60 basis points just moving into securitized products within the front end of the curve. And then we like the longer end of the IT curve. So, in that seven- to nine-year part of the curve, we have really attractive carry and roll down. Barbelling that with short data securitised, we think that’s a really interesting way to think about the market.
You construct a portfolio with high 5% yield with that kind of framework and that’s a six-year duration product, that’s pretty attractive.
EM – I agree with you on that one. Could we perhaps touch on interest rates?
SB – We think the Fed is likely to realise the number of hikes that’s priced into the market. If I was to take a directional view relative to the market, I think there’ll probably be fewer hikes relative to more, but we do think the market is pretty fairly priced here in terms of FedEx expectations. The underlying economy, GDP and investment is pretty healthy. The consumer seems like it’s in reasonable shape. So, it would not surprise me if yields continue to migrate, drift a little bit higher here as we make our way into the back half of the year. That’s just simply based on fundamentals and that wouldn’t be a bullish or bearish thing for credit or for risk assets.
That drift upwards likely implies a marginally flatter curve as the long end likely starts to become a little more anchored here. But then as we fast-forward into next year, I do think things start to get a little more interesting as we make our way into Q2 of next year. In 2Q27, you have extremely difficult corporate comparables because Q2 earnings were so good this year. In the early part of this year, you have very high inflation because of the conflict. That becomes a rather easier base effect to clear. It’s going to be difficult for nominal GDP to continue to accelerate at the pace that it is for the next several quarters.
So, I sort of have that Q2-ish timeframe next year where maybe we start to get a little bit of a growth scare or a little bit of a deceleration in both growth and inflation. Earnings are a little tricky. Maybe that’s an environment where risk assets have a little bit of an air pocket. That’s an environment where rates might catch a little bit of a bid. Again, that’s pretty far out into next year, but you can paint a picture where first half of ’27 becomes a little more supportive for bond yields, bond prices appreciate, maybe introduces a little bit of pressure on risk assets and you have some volatility around that window that’s a little more fundamentally generated as opposed to policy driven or conflict driven.
EM – That’s terrific insight. Thanks for that. Finally, it’d be remiss of me not to ask you about what you think about Australian IG credit?
SB – It’s growing, right?
EM -It is growing.
SB – You’re going to get a lot of hyperscaler issuance down here. They’re looking for all pools of capital to tap.
We’ve actually been more active in Aussie IG than what we have been historically. We have a little bit of backup and spreads and valuations became slightly more appealing. The hedge economics have improved on the margin as well.
EM – Just finally, is there anything you would like to speak to our readers?
SB – I think when you think about the global investment grade market, I think there’s this growing segment of the asset class where active management can really generate outsized returns or outside sources of alpha. When you think about moving away from traditional benchmarks and moving away from the traditional or liquid public markets, this grey area of semi-public, semi-private, semi-corporate, semi-securitised, it doesn’t have a natural home. It doesn’t have a natural buyer base. You can harvest some complexity premium, you can do some credit work and find some proper mispricings. I think that’s an area of the market that increasingly just gets overlooked.
You’re not going to have access to that market from a traditional passive product, from a passive ETF. And that’s where I think active management, particularly active credit management, can really start to set itself apart over the next 12 to 18 months.
We haven’t seen this opportunity for portfolios and for clients, in a while within high quality credit. It’s probably been since the early 2000s when we’ve had this much opportunity, this much dispersion, and really just this much of a window to really prove out the use case for active management.
EM – Steve, that’s excellent. Thank you so much for your time.
