The credit spreads between government bonds and investment grade bonds have widened significantly since mid-2014, from 1.04% to 1.88% (over 80%), and from 3.42% to 7.26% on high yield credits. The main drivers of spread widening in high yield markets are the impacts of falling oil and commodity prices affecting the energy and mining sectors.
However, for investment grade it is less clear, particularly since fundamentals remain solid overall. The main cause appears to be technical factors and in particular a rising liquidity premium as well as the impact of recent market volatility. Taking all factors together it seems that a reasonable buying opportunity is starting to present itself.
Each of the two main measures of credit valuation we use indicate credit valuations are attractive. We estimate appropriate fair value compensation, the spreads required to compensate for default, volatility and liquidity risk, to be 1.64%. This compares to current spreads on investment grade credit of 1.88%, with the key source of the fair value premium being the reward for current levels of volatility.
Economic conditions are supportive
Global economic growth is moderate and well-balanced: Europe is commencing recovery (from a low base), China is slowing down and the US is growing fairly well. Low or falling growth is negative, but rapid globally synchronised growth is not necessarily altogether positive since synchronised booms are often followed by synchronised busts, and blue sky environments often encourage companies to take unnecessary risks.
While there are increasing risks around a slowdown in emerging markets (especially as the US Federal Reserve starts withdrawing some of the surplus global liquidity), we see little risk of another global recession.
US interest rates on an upward path
The Fed’s move in December 2015 confirmed that interest rates are on an upward trajectory, and while further increases depend on economic data remaining positive, it is an indication of improving economic conditions in the US. It is unclear which of the forces will prevail in the short term – the ‘tourist money’ leaving credit or the ‘value money’ buying credit – but there is always a risk that spreads could continue to widen further.
Furthermore, while rising interest rates have historically been positive for credit market performance, there is a risk of an increase in the correlation between the two if investors sell all fixed income exposure simultaneously.
Although this has happened to some extent during recent bouts of rising bond yields, on balance we think a measured normalisation of cash rates globally as economic activity improves is positive for credit markets albeit with some pick-up in volatility.
Corporate fundamentals and increasing downgrades
While default risk comprises only a small element of the risk for investment grade companies and this remains very low, the current projection from Standard and Poor’s indicates that potential downgrades are rising while potential upgrade rates remain broadly constant. Despite some deterioration over the last quarter, the median default probability is around the same as it was a year ago. Leverage is increasing slightly, but one could argue that this is reasonable at current once-in-a-lifetime low debt costs. Increasing and lengthening debt when rates are this low could be seen as a stabiliser for credit quality going forward, while interest coverage ratios remain healthy.
Liquidity risk presenting opportunities to capture premium
The recent widening in credit spreads is also being driven by investors increasing their desired liquidity compensation. As such, there is an opportunity for investors to capture additional liquidity premium.
Over the last year issuance has outstripped demand as companies have issued a record amount of corporate bonds looking to fund at, what appear to be, very attractive yields.
The reduced liquidity in global credit markets is well-documented. The withdrawal of QE and rising interest rates in the US may precipitate a further liquidity squeeze, increased market volatility and spreads gapping wider as carry trades are unwound. In credit, any such move could be exaggerated as retail investors, who still view fixed income as a low risk asset class, may get shocked by negative absolute returns as interest rates rise and spreads widen. This fear has been reflected in the growing divergence between ‘liquid’ credit derivatives indexes and the less liquid physical credit indexes, the spread having widened from approximately 0.20% in the middle of 2014 to approximately 0.73% today.
Conclusion
So are we there yet? Credit fundamentals remain fairly strong though we have seen some broad weakening, which, given how far spreads have already widened, suggests that this is already ‘in the price’. Economic fundamentals are supportive but not spectacular and valuations look cheap albeit by no means remarkably so – especially with 2009 levels still in our frame of reference – and US rates are rising for essentially the right reasons (lower unemployment and improving growth and economic activity).
Credit is rarely traded purely on technicals. However, at present the market is trending aggressively wider for which reason prudence might argue against fully backing any valuation models while such an aggressive up trend is in place.
The backup in spreads since mid-2014 is now presenting interesting opportunities for investors to start gradually and carefully rebuilding their credit positions, especially for longer-term, patient investors who are looking to capture some liquidity premium in their bond positions
Tony Adams is Head of Global Fixed Income and Credit at Colonial First State Global Asset Management. This article is for general education purposes and does not consider the circumstances of any individual investor. Investors should see financial advice before acting on this information.