- We expect the reflation dynamic where High Yield (HY) outperforms Investment Grade (IG) to continue but the outright direction of total returns is set to be swayed by moves in underlying interest rates. Episodes when both rates and credit returns are negative, like in February, are not commonplace and we do not expect them to become so in 2018.
- In the recent outflow cycle, HY exchange traded fund (ETF) prices have been more resilient than their IG counterparts. This is logical given the duration nature of the correction. Spread volatility suggests that HY ETFs may be overtaking credit default swap (CDS) indices as the hedge of choice, as ETFs are a hedge for both interest rate and credit risk.
- The share of credit within the European Central Bank’s (ECB) Quantitative Easing (QE) programme remains elevated. At just over 18%, it offers ongoing support for euro credit technicals. At the same time, euro credit yields are creeping higher with IG yields nearing 1% and euro HY nearing 3%, attracting investor interest.
A rare downdraft in both credit and rate returns
Credit entered spring time on the back foot as most credit markets were hit by a double whammy of wider spreads and higher rates in February. The one silver lining is that HY continues to outperform IG, keeping the reflation trade on track. Global HY is down 30bp year-to-date, compared to a fall of 190bp for global IG (Exhibit 1). We expect the reflation trade dynamic to persist but the direction of total returns is set to be swayed by moves in underlying rates. In terms of the credit component, we forecast modest positive excess returns in 2018 as we anticipate a modest spread widening that is within the spread carry breakeven...
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