As with most asset classes, specific segments within credits always offer attractive opportunities. But if growth slows, the rest of 2019 will be an uphill slog for credits.
The credit markets are in a late stage of the cycle. Since the financial crisis and subsequent monetary easing, bond yields and spreads have fallen. As the central banks started to withdraw liquidity some time ago, this tailwind has subsided and the tide is actually turning. It now looks as though the spreads and yields seen in 2018 will be the lowest we are likely to see for some time.
Various signs of strain are evident in the credit markets, yet companies are still heavily dependent on them as a source of funding. Despite recent rises, interest rates are still low, making the bond market an attractive place for companies to arrange financing. Leverage levels are still very high and despite levelling off very slightly, there are certainly no signs of deleveraging. Companies are not incentivized to do so; it usually requires market pressures to set off this process – as was the case in the energy sector in 2016.
The overall quality of the credit market is a cause for concern. Since the financial crisis, the proportion of BBB-rated debt (S&P’s lowest rating for investment grade bonds) in the credit segment has ballooned, mainly due to downgrades and the issuance of triple-B rated bonds.
The BBB segment accounts for around half of the total credit market, but is two-and-a half times the size of the entire high yield market. In previous cycles, an average 10% of BBB-rated bonds were downgraded to high yield. If this happens again, these ‘fallen angels’ from the investment grade segment will make the high yield universe much larger.
Generally speaking, credit ratings lag the economic cycle. This move will therefore play a less significant role in 2019, but could subsequently have an impact on the high-yield universe. In that case, it would also put pressure on returns in the investment grade universe, as investors would be forced to up and leave.
Economic growth in 2019 will to a large extent determine if and when the credit markets start to move and whether spreads really widen. In Europe, primarily, spreads have already widened in 2018, reaching median levels. As the ECB has been buying European credits in the context of its quantitative easing program, but will stop in 2019, there is still a possibility that they will widen further as the market’s key buyer exits the stage.
Although we think that Brexit and the discussions surrounding Italy’s budget will be off the table in 2019, we always have to factor in political risk in Europe. If the situation sours, credit spreads will be in the firing line and the banking sector (which makes up almost 30% of the European credit market) will bear the brunt of it.
As stated above, we expect the US economy to continue to grow gradually in 2019 and there to be little risk of recession. Earnings growth will take the edge off the high leverage problem. Economic growth and the associated gradual tightening by the Fed will push up interest rates.
This is already having a ‘crowding out’ effect, as the question of why investors should still invest in credits when Treasuries offer lower risk and very similar yields is becoming more and more relevant. In that respect, spreads need to widen. Absolute yields are quite a bit higher in the US than in Europe, but while – to all intents and purposes – this sounds attractive, euro investors are facing mounting hedging costs, wiping out most of the extra return.
So, should investors shift into the riskier high yield bond segment? There could be even more turbulence on the horizon here. Quality is a cause for concern, too. The Moody’s Loan Quality Index, which tracks the quality of covenants, is at a very low level, which is generally seen as a sign that we have reached an advanced stage in the cycle.
In addition, high yield bonds are sensitive to economic decline, which is often accompanied by an increase in bankruptcies, for example. The spread on high yield bonds is relatively low, which means they offer very little in the way of a buffer in the event of negative news. For the broader credit market, both in Europe and the US, most of the signals have been flashing amber for a while. And, as we know, amber is followed by red.