Credit market monthly review: Oktoberfest ahead of festive season
Credit market monthly review: Oktoberfest ahead of festive season
- October’s dovish European Central Bank (ECB) meeting boosted euro credit while heavy supply weighed on US dollar credit. On the downside, EUR credit’s spread advantage over USD is vanishing fast, although European macro momentum and ECB quantitative easing (QE) on a €30mn per month ‘autopilot’ until September 2018 do support this.
- A bull run in spreads for nearly 21 months, combined with low underlying rates, has squashed credit yield break-evens, leaving little margin for error. Our fair value model flags this asymmetry in credit risk, implying a spread widening by 6% in USD investment grade (IG) and 12% in EUR IG over 12 months, for base-case growth and volatility expectations.
- High yield (HY) should exceed 8% and IG should exceed 5% in total return in 2017. The strong rally in implied volatility makes credit default swap (CDS) index payer strategies quite attractive for locking-in 2017 portfolio performance.
Tighter, lower, steadier
Credit markets currently resemble the intertwined feel-good narratives of the movie ‘Love Actually’, namely healthy economic growth, strength in corporate earnings, elevated sentiment data, a dovish ECB stance, an upgrade in Italy’s sovereign risk, a cooling off of the situation in Catalonia, manageable supply in primary markets, and investors with cash to invest. As a result, the scene is set for a good run into year-end, compelling investors to stay invested despite stretched valuations and low break-evens, the result of tight spreads and low underlying rates.
Credit enjoyed another strong month in October and August’s jitters have long faded into memory. It was the turn of EUR credit to outperform boosted by a dovish ECB outcome on 26 October, as one third of the tightening in EUR IG came in the last three sessions of the month. Stateside, USD credit went into a ‘holding pattern’ ahead of the release of the tax reform plan and heavy supply also weighed on spreads ($118bn in October in financials and non-financials, a new record for the month of October).
EUR credit advantage over USD yet narrower
The strong performance in EUR credit has helped year-to-date EUR HY returns overtake USD HY, no mean feat considering the carry handicap of EUR HY due to low benchmark rates (-0.4% 5y bund yield vs 2% 5y US treasury) and a high BB content (75% of EUR HY is BB rated vs 48% in USD HY). The downside to this outperformance is that the EUR credit spread advantage over USD credit has narrowed materially in IG, or has outright vanished, in HY. That said, a solid growth backdrop in the euro area and an ECB asset purchase programme on ‘autopilot’ at €30bn per month until September 2018 should continue to underpin euro credit spreads over a 6-12 month horizon.
Credit risk asymmetric by most measures
Stubbornly low underlying rates have combined with the 21 month-long bull run in credit spreads since February 2016 to push yield break-evens ever lower. Indeed, duration-adjusted yields have dropped towards their historical lows in USD credit or broken below their prior historical lows in European credit (well below in the case of EUR credit). At a meagre 12bps, the EUR IG yield break-even leaves little margin for error.
A spread sensitivity analysis based on our macro fair value model for IG credit also highlights the credit risk asymmetry at current spread levels. Out of the four model variables we hold corporate debt to GDP and corporate profits to GDP constant, while we adjust real GDP growth and equity volatility according to our base case scenario. Steady or slightly lower growth and an uptick in equity volatility – due to gradual central bank policy tightening – imply a modest widening in USD IG by 6% and a somewhat more notable widening in EUR IG by 12%.
CDS index hedges can help lock-in performance
HY should exceed 8% and IG should exceed 5% in 2017 total return, assuming no capital gain or loss from now to year-end. Hedging strategies via CDS index payers are worth considering for locking-in performance over the rest of the year, more so following the recent rally in implied volatilities that has lowered their cost further.
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