23 September 2021
Keep calm and carry on
Corporate credit continues to provide opportunities to earn carry against a backdrop of slowing growth momentum and tight spreads.
Although growth momentum has slowed, the fundamental outlook heading into the third quarter remains constructive. US corporate balance sheets remain strong, with second-quarter corporate earnings surprising over 10% to the upside and US investment grade net leverage now at its lowest level since December 2018. If consensus earnings estimates for 2021 are achieved, leverage could fall to its lowest level since 2015, which would further strengthen balance sheets. On top of strong earnings, the attractive fundamental backdrop is also being supported by the seemingly limitless provision of liquidity from central banks. However, tail risks have risen, with the spread of the Delta variant, continued supply chain constraints and the recent volatility surrounding China all having the potential to cause bumps in the road. At the moment, we think these risks are temporary. Vaccines have continued to mitigate the Covid-19 pandemic, with hospitalisations and mortality rates remaining relatively low despite rising case counts. Supply constraints look to be a timing mismatch as economies reopen, rather than a long-term structural problem. And although Evergrande’s collapse has caused uncertainty, the overall impact on the bond market has so far been relatively measured as investors have been able to differentiate within the China real estate complex. Our base case is that Evergrande does not pose a systemic risk for the Chinese or the global economy.
Spread compression has been one of the main drivers of returns in the high yield market year to date, with global high yield spreads compressing by 35 basis points (bps), as of 21 September. Both US and European high yield spreads are near five-year tights, with US spreads sitting at 318bps and European spreads sitting at 292bps. Month-to-date returns for the high yield market have also been strong, with US and European high yield returning 0.68% and 0.66%, respectively (as of 17 September). This strong carry environment is not only a high yield story: subordinated bank capital, such as European Contingent Convertibles (Cocos), has also performed well. Recent European Union bank stress tests have been encouraging for the region’s lenders, which registered resilient results even under the most stringent test scenarios. As a result, European subordinated bank capital has been one of the strongest performers this year, returning 4.40% year to date. Current European CoCo spreads at 357bps are still 93bps away from five-year tights and could therefore provide an attractive opportunity for carry and further spread compression. Data as of 21 September 2021.
European subordinated debt offers attractive total return prospects via spread tightening and carry
The technical backdrop for high yield remains supported by the relatively low duration profile of the asset class, as well as the ongoing hunt for positive yield and lower duration, particularly from unconstrained and institutional investors. Weaker-than-expected supply has further exacerbated high yield returns so far in September. European high yield gross supply was expected to be between EUR 20 billion and EUR 25 billion this month, but so far we’ve seen only around EUR 4 billion in issuance. The story is the same in the US, where month-to-date supply has been just USD 19 billion compared to an expected USD 50 billion. We do expect supply to increase later in the year, which could present a buying opportunity on the back of any spread widening. Data as of 21 September 2021.
What does this mean for fixed income investors?
In our recent Investment Quarterly meeting we lowered our “above trend growth” probability from 90% to 80%. It is clear that global growth momentum has slowed due to near-term concerns over the Delta variant, supply chain bottlenecks and Chinese regulatory reforms. However, we see these risks as temporary and expect the growth backdrop to remain supportive, albeit not as strong as earlier in the year. With spreads near their recent tights, we are in a carry environment and therefore prefer risk assets, such as US and European high yield, non-agency securitised credit, leveraged loans and bank capital.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum