The first quarter of this year turned out to be an exceptional time for the credit markets, but the second quarter is putting in much more standard performances: after a historical rally for credit spreads in 1Q, the second quarter was characterized by volatility during May, mostly as
a result of renewed US-China tension.
During the first quarter, credit marketinvestors had bought the idea that the US and China would soon come to a trade agreement at some point during the second quarter, but the US unexpectedly took a harder line, undermining this scenario and hampering world macro-economic fundamentals. Central banks’ monetary policies are set to remain accommodative and will shore up the credit market.
In our opinion, investment grade valuations are now attractive again at Euribor +75bps vs. a 3-year average of Euribor +58bps.
Valuations are attractive again
Credit spreads widened 25bps in May, so in our opinion, investment grade valuations are now attractive again at Euribor +75bps vs. a 3-year average of Euribor +58bps. Technical factors were on a solid trend in 2Q and will now be bolstered by the prospects of sustainably low interest rates. Inflows on IG credit funds are sound and steady, at around €8bn YTD, while the primary market is still at the cruising speed seen over recent years with issues of close to €54bn in May. Despite widening credit spreads, the European investment grade market displayed gains of 0.65% in 2Q vs. a rise of 4% YTD.
The high yield market continued on with its performance in 2Q – much like investment grade – although showings were not as robust as in 1Q, mainly fueled by carry. Some investors opted to take profits, while overall market sentiment became more cautious following US-China tension. High yield spreads widened in May, but were still only 20bps wider than the average over the past three years. The segment provides stronger yield than sovereign bonds, and this could potentially attract investors.
Fundamentals for high yield companies remain solid and default risk is limited. Investment flows slowed during the second quarter of the year, although they remained positive and could surge again over the months ahead. The primary market was still active and moderate, faced with loan market competition on new issues. We remain confident on future performances for the high yield segment.
Fundamentals for high yield companies remain solid and default risk is limited.
There are two main potential scenarios for the credit markets to at least remain resilient, if not positive, in 3Q:
- Heightened tensions between the US and its trade partners, which would dent the economic outlook. In this type of scenario, central banks would ramp up accommodation to offset the impact of this conflict, which could entrench risk-free rates at a lower point and trigger an outperformance from the credit markets due to investors’ moves to seek out yield, and in light of negative risk-free rates.
- An improvement in the international geopolitical and trade outlook, which would include an outperformance for risky assets – particularly corporate debt – if it were to ward off the threat of an economic slowdown and prompt an interest rate hike.
Deterioration in credit quality
The European leveraged loans market was buoyed by high demand for CLOs – with issues up 8% at mid- June on the back of Asian investors’ interest – and private debt funds this quarter, as we expected at the start of the year. The primary leveraged loan market was unable to meet this demand, with a 44% decline at mid-June as compared to 2018, and this disproportion should last throughout the summer, as CLOs issued since the start of the year have to invest massively in the first six months after issue. Default rates remain low, but leverage continued to rise and credit quality declined further with favorable legal documentation for borrowers. Widening spreads did not offset this deterioration and the situation is unlikely to change in the short term. Lastly dispersion – often a reflection of the market’s confidence – continued to increase as we expected. We are convinced that the keys for outperformance for credit investors will be stock-picking and a discriminatory approach between issuers, especially against a backdrop of low interest rates.