Are credit markets predicting recession?
Credit spreads widened in 2015 and have remained under pressure in early 2016. However, there has been significant dispersion in performance across regions and investment grades. This provides selective opportunities for savvy investors.
What is going on in credit?
Although credit markets came under general pressure last year, there was still considerable dispersion in regional performance. European high yield significantly outperformed US high yield; sterling investment grade outperformed euro investment grade and Asian emerging market (EM) credit was a strong performer despite the worlds’ concerns over China.
However, there has been a weak and much more correlated start to 2016. Therefore, the question for the next six months is whether investors should expect another year of a volatile but dispersed range of regional performance outcomes, or if we are about to enter a broader bear market that anticipates a global recession. Aside from direct forecasts of GDP growth, some of the indicators we use to assess where we are in the credit cycle include trends in bank lending standards, corporate leverage levels and the flatness of government yield curves.
On the first criteria, lending standards have tightened in emerging markets and there are nascent signs of tightening in the US, but European lending standards are still loosening. On the second, corporate leverage is relatively high in the investment grade sector, but remains lower than during the 1990s once the energy and commodity sectors are stripped out. Finally, although yield curves have flattened, they are steeper than has traditionally been associated with recessions. Meanwhile, defaults have been rising, but only from historically low levels and are generally a lagging indicator.
High yield action
What has been particularly interesting is the price action in US high yield, one of the worst performing credit markets in 2015 with a circa -5% return. If we look at the
range of returns for individual bonds within this market over the past four years we find that in 2012, the vast majority were positive. However, the variation in performance has increased in each subsequent year, culminating in 2015, when close to 50% of bonds produced negative returns and a reasonable number of bonds entered distressed levels.
Just over 20% of US high yield issuers are in energy and commodities and were therefore highly vulnerable to the fall in commodity prices. However, distress has also been
seen in some other areas such as retail and certain parts of telecommunications. Greater risk aversion has caused more general dislocations which will need to be watched to see if they subside as we get more clarity on the economic outlook in 2016.
While global high yield is now offering a 9% yield, this would still have some way to go before it reached normal recessionary levels. This is different to US investment grade, where credit spreads have already reached the peak levels for two out of the past three US recessions, although they are still some way off 2008 levels. We need to be careful about simplistic comparisons over time: there are more BBB rated bonds now in the benchmark; the average duration has increased and there is some commodity exposure and so we would expect spreads to widen further if there was a global recession.
However, good-quality issuers now look cheap and while you would not want to own a number of smaller regional US banks because of their over exposure to commodities, it is a different story for the large US banks such as JPMorgan, which have strong balance sheets with low book exposures to commodities.
Leaving aside commodities, the other source of market worry has been EM. However, many of the areas with the most negative headlines were actually some of the better
performers in 2015 because the market had priced too much in by the end of 2014. For example, Russian corporate credit had a very strong performance in 2015 despite Russia’s myriad problems. Similarly, the Chinese economy may have slowed, but Chinese credit has outperformed, particularly property bonds. The lesson is that there are opportunities and not just risks in EM credit. The upshot is that we expect another year of volatility in credit markets, but the risk of recession appears lower than the market is pricing in. This is an environment of selective opportunities. In high yield for example, our Funds benefited from a materially reduced exposure to the most risky CCC rated debt in 2015, but it is still too early to reverse this position despite the wider yields on offer.
Craig MacDonald, head of Credit at Standard Life Investments.