When growth is not too hot to prompt rate hikes, and not too cold to raise default rates, could credit be just right?
In a world of mediocre growth that is not strong enough to prompt central banks to hike rates but is consistent with a low incidence of defaults, credit typically outperforms in terms of risk and volatility-adjusted returns.
Over the last twelve months, the shadow of rising recession risk has prompted investors to favour higher-quality over low-rated and cyclically sensitive credit.
But even with the mediocre recovery in the global economy that we anticipate, there is room for catch-up in performance from lower-rated and cyclical credit.
Credit potentially offers low volatility and positive returns in a world of mediocre growth not too hot to prompt central bank rate cuts and not too cold to raise default rates.
In Europe, investment-grade corporate credit has become a quasi-safe asset for many investors unwilling to hold negative-yielding, high-rated European sovereign bonds.
The ECB is committed to buying EUR20 billion of bonds every month until inflation sustainably converges to its near 2% target, of which EUR4-6 billion is purchases of investment-grade corporate bonds.
In our opinion, investor, as well as ECB, demand for investment grade credit could see a further grind tighter and compression in spreads between higher and lower-rated debt, even if eurozone economic data remains tepid.
Mediocre growth is good for credit
Note: average quarterly total returns; USHY (BAML US High Yield Master 11, HOAO); US IG (BAML US Corporate Index, COAD); UST (BAML US Treasury & Agency Index); and S&PS00 total return index in the quarter with US GDP growth below 1% (SAAR); 1%- 2%; and above 2%. Latest data for Q3 2019
There is approximately USD12 trillion of negative yielding debt (mostly European and Japanese government bonds), accounting for almost one-quarter of global fixed income assets.
Only some 10% of debt issued in the major domestic and Eurobond markets yields 3% or more – mostly sub-investment grade-rated developed market credit and emerging market debt.
Against this backdrop, the subordinated debt of investment grade-rated companies and banks offers attractive risk-adjusted yields.
European bank debt, especially contingent convertible bonds (cocos), offers mid-single-digit yields and a meaningful spread pick-up over similarly rated non-financial corporate debt.
Rating agency and regulatory changes could also be supportive of the asset class in 2020 and it remains a core holding across BlueBay multi-asset and credit strategies.
European banks improving credit fundamentals
Source: ECB (European Central Bank), Eurostat 2019 Q2, 2019 Q2
Bank credit fundamentals have improved dramatically since the global financial crisis and bank debt capital offers among the most attractive risk-adjusted returns in a low-yield environment.
In a low yield world, US and emerging market (EM) ‘hard currency’ credit continues to attract inflows from global investors seeking yield.
Currency hedging improves the yield opportunity set for North American investors with returns on euro-denominated debt boosted by more than 2% by hedging back into US dollars (and why ‘reverse Yankee’ issuance by US companies of euro-denominated debt will continue to be an important source of supply).
For Asian and European investors, the funding cost of US dollar assets and flat Treasury yield curves erodes much of the additional yield on offer from US fixed-income and credit, although investors are increasingly taking currency unhedged exposure.
The heavy supply of bonds has been a persistent performance headwind for US investment-grade debt, but in 2020 is expected to be around USD400 billion – down by more than 20% from 2019 and approximately half the record highs of 2017.
Moreover, low rates, a bounce-back in corporate earnings and investor (and rating agency) pressure on BBB-rated companies to reduce leverage should be supportive of credit fundamentals after several years of gradual deterioration.
The combination of stable credit fundamentals and improving supply-demand technicals should keep credit spreads well-behaved and allow coupon plus returns (some 3%-4%) in 2020, in our view.
Global investment grade & high yield credit spreads
In leveraged finance markets, 2019 was characterised by a rise in dispersion and rising idiosyncratic credit risk, as well as stress in the US high yield energy sector.
We believe the rewards from bottom-up fundamentally driven credit selection is greater than ever.
The lowest-rated segments of the global high yield market have underperformed higher-quality BB-rated and less-cyclical credit.
Yet non-energy default rates are expected to remain low and, despite the spread tightening this year, investors are fully compensated for actual and expected default risk in a mediocre but positive growth environment.
Convertible bonds can potentially capture a share of the equity market upside while preparing portfolios to weather episodes of volatility.
There is room for lower-rated credit, especially in leveraged finance, to catch-up after lagging higher-quality debt in 2019. But greater dispersion and idiosyncratic risk underscores the importance of bottom-up credit selection.
Leveraged loan performance has notably lagged high yield bonds in 2019. The switch from rising to falling interest rates rendered the floating-rate feature of loans less attractive to investors with persistent outflows from US retail investors.
In addition, erosion of covenant protections for creditors and rising leverage of new loan issuance to fund leveraged buy-outs and dividends against the backdrop of weakening growth has resulted in a rise in loans trading at distressed prices (80 cents or below).
If our forecast for a pick-up in the global economy is realised and rates remain on hold, the demand for low-duration credit products will likely increase.
Widening US loan & CLO spreads
Source: Bloomberg; latest data at 22 November 2019
Credit spreads on collateralised loan obligations (CLOs) have widened, even relative to similarly rated loans.
In part, the underperformance of CLOs is due to adverse supply-demand dynamics that is likely to correct in 2020 with reduced issuance, as well as fears of a wave of rating downgrades on loan collateral.
The spread pick-up on BB and low investment grade-rated (‘mezzanine’) CLO tranches is the greatest since mid-2016.
For investors able to take advantage of dispersion in credit markets, we believe CLOs are an attractive option, subject to careful analysis of CLO managers, the underlying collateral and the documentation.
The rise of total return credit strategies that can invest across geographic markets and various credit sub-classes provides investor acknowledgement of the benefits of a strategic allocation to credit unconstrained by a single market, credit asset and benchmark.