The use of relative value credit analytics is not new, but the importance of this methodology has come into sharper focus and has been the subject of increased investor attention over the last 12 months.
There are two main reasons why relative value credit strategy has become a hot topic in the last year. The first is an extraordinary surge of issuance seen in bond market. The second is the extreme volatility within the credit sector in the face of COVID-19. Both these phenomena have created significant opportunities for realisation of value, and although, by the time of writing (end of May 2021), the markets have calmed down considerably from the turbulence seen 12 months earlier, the party is not over yet.
Relative value credit strategy depends on the isolation of a pair of similar credit instruments, one of which is assessed to be comparatively undervalued or overvalued. These might be bonds issued by the same borrower but at different points of the yield curve. Or they might be bonds issued by different but similar borrowers. Straightforward credit analysis of cash flow and balance sheets of two seemingly similar pharmaceutical firms might produce the revelation that one deserves to be trading at tighter yields than the other. Such a revelation invites a long/short trade.
Of course, to be able to spot the opportunities, investors need both adroit analysis and powerful digital technology at their disposal. They have to able to survey the entire credit landscape to isolate the potentially profitable dislocations and then execute trades quickly before they vanish. Risk managers also need state of the art tools to measure and report on portfolio risk at all times.