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Credit market monthly: Markets on a steady footing into fourth quarter

Credit market monthly: Markets on a steady footing into fourth quarter

Authors
Greg Venizelos, Senior Strategist - Credit, IG, HY and SSA
Insight

PDF 245.6KB

10 October 2017
  • The reflation trade strikes back as September saw interest rates rise, the dollar move higher, high yield (HY) credit gains and investment grade (IG) returns in the red. This pattern could persist into year-end.
  • Renewed hopes around fiscal stimulus in the US and relative value considerations are near term tailwinds for USD credit which reversed its recent underperformance vs EUR credit in September.
  • Duration aversion, the hunt for yield, healthy growth/earnings, and a potential US tax reform plan, are all supportive for HY markets. USD HY market could hit double digit returns if spread tightening persists.
  • A higher share of credit purchases post ECB QE tapering in 2018 could help address European government bond (EGB) scarcity issues, while simultaneously underpinning EUR credit technicals, killing two birds with one stone.

Safety in shorter duration

Rates giveth and rates taketh away. In a reversal of the pattern seen in August spreads moved tighter in September. However, given the material rise in government bond yields, this only served to help HY total returns to stay in the black. GBP IG, which has the longest duration in credit markets, was hit particularly hard, suffering a drawdown of almost 2%. This is an apt demonstration of the benefits of short duration exposure against the current backdrop of rising yields.

Headlines around consumer energy price caps in the UK could weigh further on GBP IG given its high share of utilities (19% of the GBP IG index). The duration impact in September has also restored the HY advantage over IG, with global HY now ahead of global IG by approximately 3% year-to-date (7.2% vs 4.3%).

USD credit looks strong into year-end

USD credit had its best month for more than a year in September, outperforming its developed market peers in both IG and HY (although it did underperform the areas in emerging markets credit that are associated with oil and commodities). This was partly a catch up after lagging the retracement in spreads from the August wides, but also a boost from the revival in hopes for US tax reform in mid-September. US tax reform is a performance driver that could persist into year-end as investors continue to favour USD credit. Another factor reinforcing this trend is the diminishing advantage of EUR over USD credit as the relative value of EUR credit has narrowed dramatically following the multi-month post-Macron boost, something we identified last month based on our ‘spread per unit of risk’ measure.

Optimism for global growth and the rebound in the oil and commodity complex added to the positive sentiment towards USD credit, helping USD HY to deliver strong performance in September. All but two small sectors in USD HY posted positive returns led by energy, which generated 3.3% for the month or almost two thirds of its year-to-date return. Duration aversion, the hunt for yield, healthy growth and company earnings, plus potential US tax reform are all supportive for HY markets and ETF fund flows appear to be corroborating this. In particular, the USD HY market could hit double digit returns in 2017 if spread tightening carries on and through the 2014 tights, although this would temporarily go against our expectation for mild spread widening over the next 12 months, based on historical mean-reversion. Assuming no capital gain or loss until year end, USD HY is set to reach a total return of 8.4% for 2017 (+1.3% from here), EUR HY 6.6% (+0.6%), USD IG 6.2% (+0.8%) and EUR IG 2.1% (+0.2%).

ECB credit purchases – killing two birds with one stone

ECB QE purchases rebounded strongly in September to €62.6bn (104% of the €60bn target) from €50bn in August. Out of the €62.6bn, corporate purchases represented €8bn, a new high in terms of the share of total purchases. This chimes with our view that corporate debt can help alleviate sovereign debt constraints as the timeframe for the ECB’s QE programme is extended but tapered into next year. Under a scenario where credit purchases are held at €8b per month while the overall QE purchase amount is reduced to €40bn per month from January 2018, the ECB could alleviate sovereign debt scarcity pressures while continuing to underpin technical conditions in EUR credit at the same time, in essence killing two birds with one stone. 

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