Credit: Running late but room to run
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- Central banks continue to support global credit markets, but the rate regime is changing
- Fundamentals have improved while technicals are still supportive and dominate
- Political risks in Europe and in the US could heighten credit volatility
Credit markets remained firm in Q2 2017 and H1 2017 despite already tight valuations with high beta cohorts of the market outperforming, including high yield and BBBs within investment grade. Most segments of the market have posted positive excess returns. In the US, the strong performance has been driven by improvement in fundamentals but more so by positive technicals owing to strong demand from yield-sensitive buyers with the latter a particularly dominant theme for investment grade.
An important shift since the beginning of the year is an increasingly challenged political landscape in the US, in which expectations of fiscal stimulus delivery have largely reset lower, though credit markets have not fully priced this in by most measures, including tighter spreads relative to pre-election levels as well as persistently low credit volatility (Figure 1 and Figure 2). Thus, expectations for significant out-performance are low, though we do believe this extended credit cycle has some legs left given the positive technical backdrop.
In Europe, accommodative central bank policy, most notably the ECB’s corporate sector purchase program (CSPP) has supported credit spreads so far this year and European credit has outperformed US year-to-date in excess returns. While the pace of central bank buying is decelerating, the credit purchase program is holding up well and we believe the eventual unwind will be a slow and orderly one, especially with the ECB closely monitoring subdued inflation. Still, with limited upside against a backdrop of potential tapering, we expect modest room for performance.
Technicals - structural tailwinds
The reach for yield has been a key driver of spread compression, particularly for USD investment grade credit year-to-date and we expect this to continue. All-in yields in US corporates generally remain higher than elsewhere in the global fixed income context despite some fluctuation in hedging costs back to local currencies. Many investors believe Treasury yields will rise faster than other government bonds, which helps set the stage for spread compression in credit, benefitting from increased demand by the marginal foreign buyer. Leveraged credit has also benefited from the reach for yield as evidenced by strong net flows to loans (Figure 3). Additionally, pension funded status has improved, particularly from gains in equity markets, which provides a structural tailwind for credit from increased asset allocation into the asset class.
Tailwinds too exist from the supply perspective – while USD investment grade credit has seen a heavy amount of new issuance so far this year, with many issuers taking advantage of low rates and the move tighter in spreads, we expect reduced supply in the second half of the year. Issuance has been front-loaded, in addition to subdued M&A-related issuance that is well off the peaks reached in past years (Figure 4).
A key focus in Europe is the corporate sector purchase program and the changing pace of QE. In early Q2, expectations were set for the ECB to start tapering purchases in both the government bond and the corporate program proportionally; however, this has recently shifted as the proportion of corporate purchases has trended higher. That, coupled with subdued inflation data recently, makes us believe the eventual unwind will be a slow and orderly one.
Fundamentals - improvements in leverage and earnings
In the US, fundamentals have seen improvement over the past quarters – most notably in revenues and earnings with investment grade seeing low single-digit increases and high yield seeing low double-digit increases. Profit margins have seen modest gains in prior quarters and stand at the highs post-GFC for both investment grade and high yield. We continue to expect modest improvement in coming quarters, from the generally strong economic backdrop as well as from robust M&A in prior years that is becoming accretive.
Leverage has stabilized and seen modest improvement, though absolute levels do stand near post-GFC highs for both investment grade and high yield. Interest coverage has declined since 2013 for both investment grade and high yield, but has also stabilised in the past quarters and absolute levels remain comfortable, which is particularly important for high yield (Figure 5).
As it relates to default rates, high yield default rates have trended lower, running well below its long-run average and importantly, expectations are for a further decline in default rates (Figure 6).
So what are the risks? Mostly political
Credit markets have demonstrated resilience so far this year despite a number of risk factors both credit market specific and not, including large supply volumes, lower oil prices, lack of progress on tax and regulation reform in the US, election risk in the UK, and EM risk flare-up.
At this juncture, political risks are the key ones that could derail the positive sentiment and heighten volatility in credit markets in our view, as opposed to fundamental. In the US, the budget for fiscal 2018 and the debt ceiling issues are focus points in Q3 2017 as well as a potential government shutdown. Negative findings from FBI investigations regarding collusion in the Trump administration would also be detrimental, particularly if the developments significantly delay or stop progress on the fiscal agenda.
In Europe, while the outcome of the French elections has removed some uncertainty, political risks remain elevated with the elections in Italy a potential source of volatility. Other sources that may induce a risk-off environment are geopolitical in nature, including headlines out of North Korea or the Middle East, and more generally, hard economic data not converging with the soft confidence data over time.
Putting it all together in the context of valuations
Credit spreads have been grinding tighter so far this year, whether in investment grade or high yield. In the US, investment grade credit spreads are approximately 30 basis points away from all-time tights and approximately 15 basis points away from post-GFC tights in 2014. Accounting for the structural and fundamental differences in the landscape, such as a larger proportion of BBBs, longer duration, and higher leverage that may impede spreads today from reaching the all-time tights, we do think spreads can test the more recent tights given the positive technicals and improvement in fundamentals. As spread dispersion within credit is low, we view taking on idiosyncratic risk in high conviction ideas as appropriate.
In high yield, while valuations are not particularly appealing either – global high yield spreads 20 basis points away from 2014 tights and 140 basis points away from all-time – we also expect the combination of strong technical factors and low default rate expectations to drive spreads tighter over the medium term with idiosyncratic risk taking and owning convexity key. Thus, while the credit cycle is running late, we do see the cycle as having more room to run.
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