Credit investors have enjoyed a stellar start to the year.
Does this recent strong performance mean the good times are already over?
We think the case for credit remains strong, but a shift in the backdrop means selectivity and flexibility will be vital for making the most of the asset class.
Boosted by recent tailwinds
After last year’s volatility, credit markets have delivered solid returns so far this year.
Powerful tailwinds sweeping in include a more dovish US Federal Reserve, the increased likelihood of a US-China trade resolution and expectations-beating corporate earnings.
Supply and demand dynamics have further boosted the backdrop, with net issuance levels subdued but investor inflows strong – attracted by the higher yields credit offers relative to other parts of the fixed income universe.
Does this strong start to the year mean all the juice has been squeezed out of credit markets, weakening the returns outlook for the rest of the year?
We think the answer is no, but with a few caveats. With the current level of default risk likely to remain low, we believe the credit risk premium continues to offer attractive compensation to investors.
But selectivity and flexibility will be key to harnessing the full potential of the asset class.
The extraordinary monetary policy that followed the global financial crisis was a positive for credit markets.
In a broad sense, bad news was good news for credit overall, with exceptionally low rates encouraging many investors to explore beyond sovereign debt into the higher yielding part of fixed income markets, pushing yields down and prices up.
However, we think the recent market rally is different and that it does not necessarily reflect a wholesale reach for yield.
What was once indiscriminate buying has now become more selective, but we believe this selectivity has been largely driven by fear, creating market inefficiencies that nimble and selective investors can seek to exploit in pursuit of compelling risk-adjusted returns.
Where swimming against the tide makes sense
While investors have shown a strong appetite for buying into the recent credit market rally, there is a palpable wariness around certain segments of the market.
Negative headlines around BBB rated credit risk is a notable theme, which has seen many investors steer clear of this higher risk, lower credit quality part of the market.
This is reflected in the meaningful underperformance of the BBB segment.
The BBB rated credit universe has tripled in size since 2009, as US corporates have taken advantage of cheap financing for M&A and buybacks.
This has helped lift the share of BBB rated bonds in US and European mutual fund portfolios from 20 per cent in 2010 to around 45 per cent last year.