Credit outlook: There is no average

The high yield market has had a good year, says Jamie Stuttard, Robeco Credit Strategist, but he warns that there is a growing question about which trends can persist.

“While the focus for most of this year has been the outperformance of BB-rated credit versus CCC credit ratings or distressed – now we see early signs of cracks in single Bs.”

Many bonds are either cheap – and often fundamentally suspect – or way too expensive relative to the average

Volatility is becoming inconsistent across other markets outside credit. “See the 2 or 3 standard-deviation moves in value versus growth stocks within the equity market, for example. On the other hand, FX volatility is near record lows – a potential trap for risk takers if volatility reverts towards the mean.”

Back in credit, market liquidity could become an issue, starting in private debt markets where leverage has risen the most. The overlap of issuers in leveraged loan and bond markets and the growth of multi-asset credit or 'MAC' funds means these different segments are more connected than before. Stuttard adds, “If the loan market shows more cracks, it is easy to foresee spillover effects to the high yield markets. Watch out for indigestion from the Big MAC.”

Meanwhile, eleven years after the first Fed QE, central banks are at it again. Stuttard points out that, with its reactivated QE – and reinvestments from the prior program – the ECB could well buy EUR 60bn of corporate bonds in 2020. Central banks are once again generating asset price inflation, while failing to meet their mandate targets in real economic prices. But in markets, what goes up, eventually goes down. It is usually a matter of waiting for a normal recession or a sharper earnings decline which is too big to ease away quickly.

“Central bank policy is creating a dependency amongst market participants on price appreciation, given that returns on cash and on Bunds held to maturity are now less than zero,” says Sander Bus, Co-head of the Robeco Credit Team.

“Since investors know this, there has for years been a bid for quality high yield, and we now also see an appetite for quality equity. In high yield, BB bonds have been driven to expensive levels. CCCs are relatively cheap but, in a bifurcated universe, buying the market average spread is not an option! Many bonds are either cheap – and often fundamentally suspect – or way too expensive relative to the average. And, there is no average… .”

The US economy is expanding at a slow pace still. The consumer is contributing 1.5ppts of the total 1.8% growth rate. “With just a single engine of growth, economic vulnerability is high,” says Victor Verberk, Co-head of the Robeco Credit Team.

Verberk argues that the US economy is now in both an industrial recession and an earnings recession. Yet not every earnings recession means a GDP recession, although the reverse is true. Still, almost every earnings recession in the last seven decades has heralded a credit bear market: it is time to stay alert, he says.

In Europe, Germany remains the weak spot. Things haven’t got much worse, but neither have they improved. The slowdown is more than just a reflection of softer China imports. If one dissects German exports by destination country, there is weakness in exports to the UK and Turkey, too, for example.

Looking at credit valuations, Verberk says credit spreads have become tight but are not yet back at the post-crisis tights. And, although valuations are skinny enough to be careful on a beta positioning, it is too early for outright shorts in investment grade.

In the high yield segment, there are very few bonds trading at the average index spread. “The difference between BB and BBB-rated bonds is close to a once-in-twenty-five-year tight. The reason is that the search for yield has been accompanied by a search for quality or safety. That means the other half of the market, that is, B and lower, trades at relatively wide levels. There are no bonds in the middle,” says Bus.

This makes portfolio construction more challenging. “Many high yield investors are moving into off-benchmark bonds, while some end clients are giving up liquidity by allocating further to private markets. The risk is they could end up stuck once the bear market begins. Positioning is the main risk in credit markets now, for the short term,” according to Bus.

He argues that one solution is to try to find the survivors in the bottom end of the spectrum, where intensive credit due diligence is required. “The lower end of the credit spectrum is becoming a higher-stakes arena.”

On portfolio positioning, the team concludes that investment grade is a better risk-adjusted proposition than high yield at current valuations, given potential economic outcomes in 2020.