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Credit market monthly: 'Carry on' to year-end, despite reflation trade fade

Credit market monthly: 'Carry on' to year-end, despite reflation trade fade

Insight

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11 September 2017

Key points:

  • Credit spreads widened in August while credit yields declined as government bond rates fell back, underpinning total returns as a result. USD High Yield (HY) looks set to reach 8% total return for 2017, USD Investment Grade (IG) 7%, European HY 6% plus and European IG 2% plus.
  • August endured negative excess returns across most credit markets for the first time since June 2016, when the UK voted in favour of Brexit. Historic norms imply negative excess returns 12 months forward, consistent with our view for mild spread widening and HY/IG spread decompression.
  • The reflation trade of HY outperformance over IG looks set to come under pressure for the remainder of the year unless we see a meaningful back-up in government bond rates. That said, the default outlook remains benign and stable, thus bolstering the health of HY returns.

Credit spreads widened somewhat in August in tandem with the confined ‘risk-off’ environment caused by the escalating tensions between the US and North Korea. However credit yields moved broadly lower as government bond rates declined in the wake of investors’ flight to safety. In other words, the credit spread widening appears to be the mechanical outcome of lower government bond rates – a situation which was corroborated by the government bond curve and credit curve dynamics. The inherently longer duration IG market witnessed a higher degree of relative widening compared to the shorter duration HY market, which is quite consistent with the bull-flattening in underlying government bond curves. Net-net, the spread widening was more than offset by the drop in government bond rates, which propped up total returns for the month, keeping them in positive territory.

We expect mild spread widening over the coming 12 months

August was the first month since June 2016, when the UK voted in favour of leaving the European Union, to see consistently negative excess returns across credit markets. This should not surprise (or cause alarm) given that credit excess returns have been exceeding the historical norm since mid-2016. By ‘historical norm‘ we mean the relationship between the current credit spread and excess returns over the 12 months that follow, as determined by a regression analysis. In this framework, the implied excess returns currently, 12 months forward, are broadly negative across credit markets. This is consistent with our expectation for mild spread widening and HY/IG spread decompression in the medium term. That said, we view such a correction as a welcome adjustment in credit spread levels, rather than a harbinger of a protracted bear trend.

Looking for a healthy return performance for 2017 overall

Central bank policy withdrawal is also consistent with the HY/IG decompression theme that could further erode the reflation trade*, which suffered a material setback in August. While we have advocated the reflation trade for the best part of this year, we recognise that it looks set to come under pressure for the remainder of 2017, unless we see a meaningful backup in rates. This is particularly the case for the USD credit market where HY holds a narrow total return advantage of 70bp over IG year-to-date. That said, while HY performance may lose ground - relative to IG returns - we are not unduly concerned about HY markets in general, given the very benign and stable default outlook.

Global HY looks set to end 2017 at 8% total return vs. 5.5% for global IG, assuming no capital gains or losses for the remainder of the year, a healthy level of performance. Breaking it down by market, USD HY looks set for 8% (+1.8% from here), USD IG 7% (+1%), EUR HY 6.2% (+0.7%) and EUR IG 2.3% (+0.2%).

 

*HY outperformance over IG in total return terms

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