The good news up front: after a long period, in which credit markets seemed to offer investors little to be excited about, they are interesting once again.
Recent volatility has shaken up credit markets, leading to the most attractive valuations and income levels we have seen in over a year. The dispersion in the market has also improved, suggesting a better opportunity to generate returns through security or company selection.
No longer boring
For a relatively long time, credit markets have seemed quite boring. In the 18 months to the end of January, the yield of the European investment grade corporate bond market has struggled to reach even 0.4%. The euro high yield market averaged less than 3%.
The average yield premium (credit spread) between corporate bonds and government bonds has rarely exceeded 1% for European investment grade in this time, or 3.5% for high yield. Spread being higher than yield is unusual and is explained by negative government yields.
It has been a similar story across major corporate bond markets worldwide. At the end of 2020, the proportion of the euro investment grade markets generating negative yields was above 40%. Investors needing to generate income from their investments, were being starved of yield.
Happily for those seeking income, this is starting to change.
In the first weeks of 2022, we have seen substantial volatility in markets, driven by macroeconomic uncertainty, particularly, hawkish moves from central banks. This has brought the market’s focus to the question of how forcefully central banks will reply to elevated inflation.
At the same time, global growth is slowing. Leading indicators for the US economy, namely the composite purchasing manager indices (PMIs), dropped from 57 in December to 51 in January (above 50 indicates economic expansion, below 50 contraction). Inflation remains elevated, driven by high energy and food prices as well as more persistent wage pressures.
Yields on government debt in the US and Europe increased significantly and credit spreads widened, as central banks more decisively articulated willingness to tighten policy to fight inflation.
With three consecutive surprise hawkish moves from central banks, it is little wonder markets were spooked.
The Fed had already “engaged”, beginning to wind down asset purchases and signalling interest rate rises ahead. In January, however, its comments seemed to open the door to a faster tightening trajectory. The Bank of England (BoE) then fuelled the frenetic market activity with its decision to begin unwinding its bond holdings and raising interest rates on 3 February.
This was followed the same day by the European Central Bank’s (ECB) refusal to rule out interest rate rises for the eurozone this year.
The result has been furious selling in European bond markets, with significant tightening in policy being priced in to credit markets very quickly. Indeed, markets may have overreacted.
Taking a calmer and clearer-headed look, this market reaction, short-term pain notwithstanding, is creating opportunities. Yields have risen sharply, and are now much more attractive. This makes for a brighter outlook for the rest of the year.
Where are yields?
The yields of the euro investment grade and high yield markets have repriced to 1.1% and 4.3% respectively as at the second week of February. Neither level has been seen since 2020. Euro IG spreads, for the A and BBB rating segments, have widened above their long term median and the broad euro IG market offers a spread of around 118 basis points (bps).
Furthermore, these periods of frantic market adjustments are often highly correlated across sectors, and individual companies, and this is where dislocations so often occur. So in addition to better yield, the dispersion in the market has improved and the opportunities for bottom-up security selection have also increased significantly.
The proportion of the euro credit market generating a negative yield has come down and break-even rates have improved, providing the credit market with additional robustness. The credit break-even is the ratio of bond yields to duration, and indicates sensitivity to interest rates.
Global economic growth was already slowing down from the high levels of the post-Covid recovery. Central banks will need to balance the need to temper demand and inflation expectations, while being careful that growth isn’t choked off.
Ultimately, inflation is expected to moderate after Q1 2022, as energy price development should be more muted going forward, which could give central banks room to remain accommodative for longer. So there is scope for macroeconomic and policy conditions to revert to a more benign state in the months ahead.
A shot in the arm for credit
So although the immediate aftermath of central banks moves is painful as the market re-prices interest rate risk, what has happened could ultimately be the “shot in the arm” bond markets really needed. The extra yield and spread bring bonds back to life with scope for generating much more meaningful income and return going forward.
While credit valuations have cheapened significantly, dispersion has improved too. With corporate fundamentals in credit markets still looking strong and default rates expected to remain very low, interesting security selection opportunities will surely emerge.
The hawkishness in central bank rhetoric appears to be largely priced in to the markets and should become less perturbing to investors as the year unfolds.
Credit markets continue to provide an important source of income and the opportunity set to generate returns looks favourable again.
