Spreads grind lower in credit markets

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The corporate credit market started strongly in 2014. Christophe Auvity, Head of Global Credit, discusses the environment for corporate credit and runs through the factors he sees as explaining the excellent performance so far this year.

Perspectives (P): Christophe, do you think fixed income credit markets can remain this strong throughout 2014?

 Christophe Auvity (CA): Yes, after a very strong start (exhibits 1 and 2 show some elements of performance for credit in the first two months of 2014), yields are now close to record lows, so inevitably questions are being asked as to what will happen next. We believe the market remains supported by strong fundamentals and excellent technicals, so spreads can grind tighter. The search for yield remains a powerful force in credit markets and should not be underestimated. Recent weakness in US economic data is a result of the severe winter and does not, in our minds, foreshadow further slow growth. We expect the Fed to continue to wind down its unconventional policy measures, but interest-rate hikes are, if anything, further off than we thought at the start of the year. In Europe, the very low inflation environment means the ECB is biased towards easy monetary policy. In our opinion, this will, in combination with the slow pace of economic growth, support demand for corporate bonds as investors continue to scour the markets for yield.

Exhibit 1: Strong absolute performance from credit in the first two months of 2014

spreads grind lower in credit marketsThe high-beta credit sectors have done best (e.g. subordinated financial debt has outperformed senior financial debt and high yield has outperformed high grade, etc.). This trend is well illustrated by the compression in the spread between European high grade (represented by the CDS Main index, composed of the 125 most liquid CDS referencing European investment-grade credit) and high-yield credit (represented by the X-Over index which is composed of 40 sub-investment grade credits). At the end of February the ratio between these two indices was at its lowest level since the financial crisis in 2007.

Exhibit 2: Sector performance for European credit, YTD at 28/02/14

 Credit from ‘peripheral’ eurozone countries is another example of higher-beta credit that has done well since the start of the year. The upgrade of Spanish sovereign debt by rating agency Moody’s from Baa3 to Baa2 with a positive outlook on 21 February 2014 reinforced the positive investor sentiment on a general improvement in the ‘peripheral’ countries.

P: Credit markets have been impervious to events in emerging markets (EM) and the upheaval in Ukraine. How do you explain this?

CA: This highlights that, to a certain extent, credit is seen as a defensive asset supported by strong fundamentals – companies have strong cash positions and ample access to financing. Earnings levels are not too bad and default rates remain low. Technical factors also provide support. For example, there are significant redemptions of corporate debt this year that gross issuance is going to be unable to match and we continue to see new investor cash coming into the asset class. As I have already mentioned, the macro-economic picture is also looking favourable for credit.

P: Credit markets have seen a period of strong growth. Do you expect this to continue this year?

 CA: Yes, the European high-yield market grew strongly in 2013 with a record annual supply of EUR 141.2 billion according to Dealogic. Last year also saw explosive growth in the corporate hybrid market with EUR 21 billion of supply. So we are seeing a significant expansion in volumes across the market.

Debt capital markets are offering issuers attractive funding at a time when banks are retrenching and loan books are contracting. Both trends look set to continue, so it is likely that we will see more companies turning to bond financing. A study by Moody’s showed that the average European high-yield company has a funding mix of 40% loans and 60% bonds, versus 30% loans and 70% bonds in the US. Deleveraging by banks and financial disintermediation would suggest that the transition to an expanded use of bond financing in Europe is likely to continue.

Overall, the corporate bond market in Europe has grown significantly in recent years. From a EUR 700 billion market at the end of 2006 with 864 issues, the market represented by the iBoxx Corporates (IG) index has grown to a EUR 1.25 trillion size with 1 384 issues.

P: How you do view European corporate credit in comparison with the US market?

 CA: In my view, the US market is further advanced in terms of the credit cycle. We are seeing more signs of US companies taking on leverage. Merger and acquisition activity is picking up and there have been a number of leveraged buyouts. Some companies have been issuing debt to fund share buybacks. For a bondholder, such operations, which may add pressure to companies’ balance sheets, are typically not positive signals. European companies are lagging their US counterparts in terms of the credit cycle, so we would favour European corporate debt versus the US markets. Having said that, we do evaluate the overall environment as positive for US credit markets with the factors I have cited underpinning European markets supporting valuations in the US too.

The US market saw USD 49 billion (data from Dealogic) of new issuance in the last week of February, making it the biggest week for issuance since last September when Verizon issued a record USD 49 billion bond. Issuers are keen to take advantage of the compression of spreads and the strong demand from investors with cash to put to work. Risk premiums in US credit markets are now at around their narrowest since the financial crisis of 2007. On 6 March the average spread for US investment-grade corporate bonds was 111 basis points and 397 basis points for high-yield debt. This reflects the strong demand and the search for yield.

In terms of earnings, the European reporting season is almost over and results are mostly in line with what we have seen in previous quarters with only a slight deterioration. These results did not have a major impact on the overall level of spreads, but they tend to show that corporates are adapting to the environment. The US earnings season has more or less finished and results show that most companies exceeded expectations. These results provide further support for corporate debt markets.

P: So, in conclusion, you expect a positive year?

 CA: Yes, the environment remains positive for credit. Low growth in combination with low inflation means investors do not expect central banks to quickly change the interest-rate cycle. Clearly, there will be setbacks and corrections along the way, but the search for yield makes credit an attractive asset class in the current ultra-low yield environment. We are seeing strong demand with new issuance well oversubscribed, the volumes of deals increasing and bonds being priced inside their indicative ranges. This has been apparent for some time and reflects an environment in which there is much cash to be put to work and there are not enough bonds to satisfy demand. As said, the macroeconomic environment is favourable for credit and we maintain our positive outlook.

Christophe Auvity

Head of Global Coporate Credit

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