Is credit cheap?
By most accounts, 2016 was a strong year for US Investment Grade (IG) and High Yield (HY) credit. The Bloomberg Barclays US IG and HY Corporate Indices tightened 42 basis points (bps) and 251 bps respectively, resulting in total returns for the year of 6.11% and 17.13%. While many of the headwinds that led to back-to-back years of spread widening in 2014 and 2015 abated in 2016, the year started off on a tumultuous note as oil prices collapsed in January and February leading to an intensification of market fears about increasing defaults, declining global growth and broader banking sector contagion.
However, a series of events over the course of the next few quarters led to a reversal of fortune for the market. After oil prices bottomed in February, the European Central Bank (ECB) increased its quantitative easing program, including purchases of corporate bonds in March, the Bank of England re-introduced quantitative easing in August, measures of US and global growth improved significantly in the back half of 2016, and OPEC and Non-OPEC nations reached an agreement to curb oil production. To top things off, a surprise victory in the US presidential election saw market participants anticipate a combination of business friendly policies such as tax reform, deregulation, a holiday on the repatriation of foreign earnings and infrastructure investment.
With the markets now anticipating an optimistic scenario for domestic growth in 2017, credit spreads sitting towards the bottom third of their historical ranges, and central banks such as the US Federal Reserve (Fed) and ECB starting to move away from accommodative monetary policy at the end of 2016, we ask ourselves…is credit cheap?
While credit spreads in general are at the lower end of their historical range, here are five key factors
why we believe investment grade and high yield credit may still offer ample opportunity for further
spread tightening in 2017:
1. Trump administration policies may strengthen corporate balance sheets and improve US GDP growth:
A combination of business friendly policies such as corporate tax cuts, a holiday on the repatriation of US earnings held abroad, deregulation and infrastructure investment—if implemented—may provide a material windfall for corporate profits after tax, while an improving nominal growth back-drop could lift top line growth for the corporate sector as a whole.
2. Credit spreads have historically remained relatively stable during early stages of a Fed rate hike cycle:
3. Default rates may be close to peaking as commodity prices have stabilized:
While energy sector defaults remain elevated and broader-based default rates continued to rise in 2016, the number of distressed issuers has fallen substantially. In addition, commodity sectors have stabilized and credit conditions indices have flattened.
4. Issuance trends may stabilize should interest rates increase and earnings improve:
Total corporate bond issuance grew 2.2% in 2016 versus 2015. Should many of the suggested Trump administration policies be implemented, the need for US Dollar funding may decline as earnings abroad are repatriated and corporate profitability improves. Corporations may also choose to front-load issuance early in 2017 in anticipation of higher interest rates, resulting in a lack of supply in the back half of the year.
5. Global demand for US credit is likely to remain robust as non-US interest rates remain low or in negative territory:
US Treasury and credit product offer a material yield advantage versus the bonds of other developed market sovereigns and corporates while central banks such as the ECB continue to purchase corporate bonds weighing on global supply. In a market still searching for yield, US credit markets may offer a material pick-up over those of other developed nations.
With these factors in mind, we believe total return opportunities within credit markets continue to exist. But unlike 2016 when we sought broader beta exposure to investment grade and high yield credit, we are more constructive in our view that 2017 may provide better opportunities to take on idiosyncratic risk by focusing on fundamental security selection in select industries. As always, we believe flexibility is key to being able to quickly react to changing market dynamics, and Sentinel is well-positioned to adjust our fixed income positioning as conditions warrant.
This article contains current opinions but not necessarily those of Sentinel Investments. The opinions are subject to change without notice. Sentinel distributes this article for informational purposes only. We base forecasts, estimates, and certain information contained herein upon proprietary research so do not consider them as investment advice or a recommendation of any particular security, strategy or investment product. The information contained here is from sources believed, but not guaranteed, to be reliable. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.
Quantitative easing is a monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Graph source: Bloomberg. Date range reflects available data.
The Bloomberg Barclays US Corporate Investment Grade Index is an unmanaged index consisting of publicly issued US Corporate and specified foreign debentures and secured notes that are rated investment grade.
The Bloomberg Barclays US Corporate High Yield Index represents the universe of fixed rate, non-investment grade debt.
Yield to Worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting.
The Bloomberg Barclays US Intermediate Corporate Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and govt. related bond markets.
The Bloomberg Barclays Pan-European Aggregate Index tracks fixed-rate, investment-grade securities issued in select European currencies.
An investment cannot be made directly in an index.