A sterling July for credit

What doesn’t kill you makes you stronger: after the shock of Brexit, GBP credit indices put in a sterling performance in July, outperforming in both Investment Grade (IG) and High Yield (HY) July’s 5.2% return in GBP IG is just shy of the monthly record set in Aug 2009 (a 2nd decimal difference).

Furthermore, underlying rates contributed little to credit returns in July, as the post-Brexit rally in rates took place in the last week of June while rates were broadly flat in July. This is in contrast to the year-to-date (YTD) picture, where rates have driven a large part of performance.

In IG, rates have contributed more than half of YTD returns, particularly pronounced in GBP IG. Indeed, GBP spreads had lagged the YTD spread rally but have been catching up fast since the BoE announced its corporate purchase scheme last week.

Overall, credit spreads are reaching or exceeding their 12-month lows. HY reasserted its outperformance vs IG in July, following a brief blip in June due to Brexit. It is reasonable to expect a similar pattern for the rest of the year, given

(i) corporate purchases by both the European Central Bank (ECB) and the BoE feeding the hunt for yield;
(ii) the prospect of a ‘less dovish’ Fed in the face of US labour market strength raising the flag of duration risk; and
(iii) the European Banking Authority stress tests’ benign outcome and the recapitalisation plan for Monte Paschi reducing burden sharing risk in the near term.

These factors should prove supportive of high beta credit more broadly (spread compression). A renewed and more protracted decline in oil prices could pose a threat to HY but the $40 floor in Brent appears to be holding for now. Ditto for the decoupling between HY performance and oil prices, which has seen HY returns broadly unaffected by the down leg in oil prices in July.

If credit was to earn just its running yield from now until the end of the year, global IG could reach 9% and global HY could exceed 14% (US HY could exceed 15%) in 2016 (table below). Still, global credit should be able to achieve single-digit returns in 2016 in IG and low teens at least in HY. If one adds some spread compression into the mix, global IG could reach double digits and GBP IG in particular could see returns around the 18% handle.

Greg Venizelos, Research & Investment strategist at Axa Investment Managers

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