Chris Iggo (pictured), CIO fixed income at AXA Investment Managers, comments on current credit spreads says why investors should be considering the asset class.
Credit spreads have been widening since the summer of 2014 when the low in spreads matched the peak in oil prices. Over the period since, spreads have widened as oil prices have declined and both trends accelerated towards the end of 2015 and in the first weeks of 2016.
As evidence suggests that oil is now bottoming, it is also likely that credit spreads have peaked. While the outlook for global growth has softened over the last year the risks of an outright global recession remain low. As such we think this is an opportunity to add exposure to credit.
Spreads are wide, interest rates are set to remain low and returns from credit markets are set to be better than in 2015.
At the beginning of 2015 we were very concerned about valuations in the fixed income markets. For government bonds, this concern remains in place as the entire German yield curve approaches negative territory. However, for credit – investment grade and high yield – there has been a significant valuation adjustment.
Our view is that current credit risk premiums have moved to levels that suggest a much worse economic outcome than we expect. We do expect high yield defaults to rise over the next year or so, but the bulk of the increase in defaults will come in oil and gas, and related sectors where cash flow has been severely impacted by the decline in oil prices.
Away from this sector, however, spreads are suggesting a default rate that looks too high. In the US, spreads across investment grade and high yield, have only been higher during three previous periods in the last 30 years – the 2000-2002 recession, the great financial crisis of 2008-2009 and the European debt crisis of 2011. All three previous episodes proved to be good buying opportunities for credit.
According to Bank of America/Merrill Lynch index data, neither US investment grade (IG) or high yield (HY) indices have recorded two consecutive years of negative return since the indices were first published (1974 for IG, 1987 for HY).
On that basis there should be a positive return this year following the negative outcomes in 2015 (-0.6% for IG and -4.6% for HY). With two months of the year gone, US high yield is down 1.7% while the total return from investment grade has been +0.8%.
High yield seems to be where the value stands out. A year ago the energy sector accounted for 14% of the US high yield market. The destruction of capital value in that sector means it is less than 10% of the total today, but it is still contributing around 170 basis points of the 785 basis points of the index spread, and accounts for the bulk of the default risk and volatility of the index.
Excluding energy, the market offers a yield of well over 7%. At the investment grade level, the current yield for the US market is 3.6%, compared to a dividend yield on the S&P 500 of just 2.27%. Of course there is some interest rate risk in the US bond market as the Federal Reserve (Fed) may still raise the Fed Funds rate again this year.
However, if it does, the moves are likely to be limited and could be matched by declines in credit spreads.
In Europe the fundamentals remain supportive for credit. Growth and inflation remain below desired levels so monetary policy is likely to remain very supportive to bond markets. Some steepening of government yield curves is possible if inflation starts to recover, but both the investment grade and high yield markets in Europe are very short duration (five years for IG and 3.5 years for HY).