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A High-Yielding Haven

As an ever-more-aggressive rate-hiking cycle rocks the financial markets, might corporate credit offer a space that is both remunerative and relatively calm? Last week brought the third consecutive 75-basis-point rate hike from the U.S. Federal Reserve. The market had even priced in a meaningful risk of a full percentage point.

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The week also brought more signs of this rapid hiking cycle reverberating worldwide, as other central banks scrambled not to get left behind. Sweden’s Riksbank did pull off a 100-basis-point surprise. The Bank of England hiked by 50 basis points for the second time in a row. The European Central Bank’s president reiterated a commitment to higher rates after its first-ever 75-basis-point hike earlier this month. The Bank of Japan intervened to prop up the sinking yen.

But while the worsening outlook for inflation, rates and growth took some equity indices back below their bear-market thresholds, credit markets—often the first domino to fall in previous economic downturns or market shocks—appear open, liquid, fully functional and relatively calm.

Yield

The picture holds true wherever we look.

In U.S. investment grade bonds, average option-adjusted spreads are 50 basis points wider than they were at the beginning of the year, but 17 basis points lower than they were at their peak in July. Yields are well above 5%.

U.S. high yield spreads are 100 basis points tighter than they were in July, but average yields are near their highs, at almost 9%. Even higher-quality BBs are yielding more than 7%. And the market has been open, buying up $87 billion in high-yield new issuance and $189 billion in senior floating rate loan new issuance year-to-date through August 31, 2022.

The growth and inflation outlook is especially challenging in Europe, but that doesn’t appear to be dragging on the euro high yield market in the way it is on European equities. Spreads are 120 basis points tighter than their July peaks, and the average yield sits at around 7.5% for a substantially higher-quality market than the U.S. Euro BBs yield around 6.4%.

Even among hard-currency emerging markets corporates, average spreads are in by 60 basis points since July, while yields are at a multiyear high of more than 7%, for an average credit rating of BBB.

Resilience

This credit market resilience stands in marked contrast to previous wobbles in the economy and markets, from the market shutdown of the 2020 COVID spring, through the jitters of late 2018 and early 2016, to the turmoil of the Eurozone and Great Financial Crisis.

We think there are three big reasons for this resilience:

First, there is the “central bank put option.” It’s not unusual to hear people say that it’s expired for equity investors. Nowadays policymakers even hint at the necessity of pushing down stock market valuations. Most people believe it’s still in place for credit markets, however, albeit way “out of the money.”

The Fed’s COVID-19 interventions and the breadth of instruments that were eligible for the ECB’s asset purchase programs over recent years suggest the importance central banks place on liquid, open and functioning credit markets. We think that effectively caps global high yield spreads somewhere below the 1,700-basis-point level we saw during the Great Financial Crisis.

Second, credit fundamentals are generally strong. While real GDP growth is slowing, high inflation is sustaining nominal GDP growth—and debt interest is paid in nominal dollars and euros. Moreover, during the past couple of years of extremely low rates, many companies borrowed to build their cash balances and extend their debt maturities. As a result, much of the refinancing for U.S. high yield debt, for example, won’t be due until 2025, with only 8% maturing before then. That’s why we anticipate only a gradual and modest rise in defaults over the next two years, analogous to what we experienced in the late 1990s and early 2000s.

And finally, yields in the 5 – 9% range are proving very attractive to a diverse swath of investors who remain wary of both the risk and the return potential of equities. Those prepared to consider the European corporate hybrid market, for example, can look for opportunities in high-quality, investment-grade issuers yielding 5% or more with just two years’ duration. This helps explain why the market in new credit issuance is so open and liquid.

A Relative Haven… For Now

We have been impressed with the resilience of the corporate credit markets in the midst of what has been an epic bear market for bonds. For now, we think credit spreads can offer a remunerative and relatively calm haven amid the volatility rocking the rest of the financial markets.

That being said, we think cracks are more likely in the foreign exchange or sovereign markets than in credit, and if a crisis erupts there, credit markets are unlikely to be immune. In that eventuality, we may see just how far out of the money the central bank put option really is.

Brad Tank 28 September

Article also available in : English EN | français FR

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