The year is set to continue in the same vein as the first quarter of the year (which was characterized by remarkable performances from the credit market as a whole) with the impending threats from Brexit and the surge of populism in both international relations and the forthcoming European elections poised to raise major risks and harbor strong opportunities.
Macroeconomic fundamentals seem to point to a slowdown in the world economy, but the main central banks’ monetary policies will remain very accommodative and shore up the credit market. From a microeconomic standpoint, default rates remain historically low, while leverage is kept in check. Meanwhile all participants right across the markets have clearly singled out the issues surrounding Brexit and the European elections but failed to price them in to any great extent.
All participants right across the markets have clearly singled out the issues surrounding Brexit and the European elections but failed to price them in to any great extent.
Selection remains crucial
Performances were outstanding on the Investment Grade market with yield of around +3.2% over the first quarter of 2019 for the euro IG market and 5.2% for the dollar IG credit side, hitting a 20-year high. The showing on the euro IG market was a result of considerably narrower spreads, reflecting the improvement in credit risk perception, while on the US credit market, we have been seeing a slowdown in performance as a result of lower USD rates over recent weeks. Technical factors increased at a faster pace in Europe than the US in the first quarter as credit funds enjoyed positive inflows once more, while the prospect of low interest rates drove investors’ search for yield. Valuations have therefore become less attractive – both in terms of total yield and credit spread – and this warrants a certain degree of caution.
If we take 2018 as the benchmark, stock-picking and discernment on issuers will be some of the keys to outperformance for credit investors
Market confidence bellwether dispersion has also considerably decreased. If we take 2018 as the benchmark, stock-picking and discernment on issuers will be some of the keys to outperformance for credit investors, as confirmed by the range of credit stories that made for excellent investment opportunities in 2018. The weighting of BBB issues is often mentioned as a market risk factor, after increasing from 20% to 50% in Europe and from 30% to 50% in the US in the past eight years, but in our view, this should not act as a risk as shown by the first three months of the year:
- Market interest in corporate issues remains very high and the lack of liquidity on this segment in the interbank market is a source of performance. This segment has outperformed since the start of the year.
- Stock- and issuer-picking continues to offer a very effective safeguard against this risk. The market has now fully understood and priced in this risk, as reflected by the BB/BBB spread multiple, which stands at 2.3 vs. the 2.8 historical average. If we look at both technical and fundamental aspects, we feel that the market outlook warrants a degree of caution and that any widening in credit spreads, whether broad-based or specific, should be viewed as a potential investment opportunity on the Investment Grade market.
Despite the High Yield segment’s additional spread (and risk), we think that some investors could be tempted to take profits in light of the current outlook.
Potential entry points for High Yield
The European High Yield market notched up an excellent performance over the first quarter, with total yield of +5.12%, buoyed by renewed risk appetite as a result of attractive valuations,
as expected. Euro High Yield funds posted positive inflows of €2.7bn in the first quarter – equating to 4.1% of assets managed, and close to half of outflows in 2018 – while new issues were sluggish on the primary market, as refinancing requirements were low, so market balance was found by severely narrowing spreads by on average 100 bps. Company quality admittedly remains robust in the medium term, with low default risk, reasonable debt and sound liquidity, while technical factors prop up the market – positive inflows and weak supply – but valuations have returned to their June 2018 mark, so we remain watchful and cautious. Despite the High Yield segment’s additional spread (and risk), we think that some investors could be tempted to take profits in light of the current outlook. The market also remains exposed to today’s major risks, which include Brexit, the US-China trade war, and the European elections. The central banks’ accommodative policies should continue to act as a safety net and curb any dramatic widening in spreads. The asset class’ scope for carry also plays a vital role in its ability to cushion this volatility. Against this backdrop, we think that renewed spread volatility will provide entry points on High Yield debt but also calls for relative caution in the medium term.