During the first six months of the year, credit markets continued pretty much where they left off in 2013, grinding tighter, as investors continued to scramble to find paper after they began the year sitting on high levels of cash and feared that they would lag their respective benchmarks. Credit returns were impressive, with both the investment grade (IG) and high yield (HY) sectors posting total returns of over 5 per cent in euro as well as in dollars. What is more, this rally was achieved against a backdrop of almost continuously declining spreads which translated into very low volatility.
Looking forward, we expect credit’s positive run to continue for the remainder of the year as spreads remain more than 100 bps above the historical lows despite the current low default environment. That is, the latest release from Moody’s puts the trailing 12-month global default rate at 2.3 per cent in May, significantly below the historical average of 4.7 per cent.
Several factors point to a possible underperformance of US credit relative to its European counterpart, among which the risk for re-leveraging as dividends and share buybacks are on the rise. Also, further growth in corporate profits becomes harder to envisage against a backdrop of a stronger labour market. In the dollar fixed income market we also see a relatively balanced supply and demand technical picture, whereas in Europe, the ECB’s easing will likely result in additional liquidity (i.e. demand) and lower debt issuance (i.e. supply).
A final, albeit highly important factor that should result in the out-performance of euro credit over its US counterpart is the risk of a rise in US treasuries yields, as room for an additional fall may be considered limited after such a strong first half.
We view current US yields at odds with the Fed’s forecasts, the latest string of economic data, the rally in stocks and the imminence of lower demand for treasuries once tapering is completed. We are particularly concerned with the divergence between the market implied change in interest rates and FOMC members’ views which could trigger a sharp adjustment in investors’ expectations and, hence, in US treasuries. Since quantitative targets were removed, Fed chair Janet Yellen repeatedly had to reassure the market that even as signs of stronger growth have emerged, much more needs to be done for an increase in rates to be justified. However, in the absence of quantifiable targets, each wave of positive statistics leaves investors wondering if the Fed will wait for even more to happen. What’s more, the May unemployment rate met Fed’s year-end forecast; meanwhile, these forecasts are only published four times per year with the most recent update presented as recently as last month. On a related note, we highlight that analysts’ consensus forecast for an end-2014 10-year UST yield remains above 3 per cent.
Given these expectations we call for a decrease in exposure to dollar credit and for reducing the average maturity of the bonds held. A sharp move in US yields is likely to affect mainly dollar IG bonds (due to their generally longer maturities) as well as the demand for emerging markets, while we would expect only temporary sell-offs in euro credit markets; as such, a rebound in volatility should be construed as a buying opportunity in Europe. In contrast, we caution that exposures to emerging markets should become increasingly selective with country-specific factors taking prominence and the carry theme less supported.
In terms of sectors, in Europe we continue to favour corporate hybrids, telecoms and financials, and within the latter we see the growing segment of contingent convertible bonds (CoCos) as one of the better positioned over the upcoming months though we recognise that valuations look slightly overstretched in certain cases.
Even as signs of stronger growth have emeged, much more needs to be done for an increase in rates to be justified
Elsewhere, it has become harder to identify possible outperforming sectors and issuer selection has become increasingly important. Indeed, even as we acknowledge that at this stage there is limited scope for an increase in German government yields (the widely accepted benchmark for euro-denominated corporate bonds), we favour credit risk over interest rate risk. That is, we consider opportune to target a medium duration and derive excess returns through credit risk.
Interestingly, investors seem to share our views as the search for yield has been evident in the flows going into euro high yield funds, the oversubscription of primary issuances and the narrowing yield differential between the BB-rated bonds and the B-rated ones. Regarding peripherals we consider that the ECB created accommodative market conditions for them but we would refrain from building large positions given the impressive performance witnessed over the course of the last six months or so, and probably limited resilience if economic data were to disappoint again.
www.cc.com.mt
The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.
This article was issued by Calamatta Cuschieri.