20 January 2022
The calm in risk markets
Risk markets appear to have handled the recent rise in rates in a sanguine manner – so far. We discuss the extent to which this is likely to continue with financial conditions expected to tighten.
Given that the main driver of the fundamental credit recovery over the past year has been the seemingly limitless provision of liquidity from capital markets, the prospect of tighter monetary policy would ordinarily signal less benign conditions for borrowers. However, we believe that corporate fundamentals should remain robust, as even with a more aggressive Federal Reserve (Fed) hiking cycle, the cost of funding will still be cheap. In fact, in the near term, sponsors and management teams may even rush to take advantage of the easy financing conditions sooner via M&A or shareholder distributions. 2021 ended with fundamentals in sound shape across the credit spectrum. In US investment grade (IG), net leverage has fallen to 1.6x, its lowest level since December 2017. Similarly in Europe, net leverage has tumbled from 2.2x in Q3 2020 to 1.7x in Q3 2021, its lowest level in nearly five years. In US high yield, the trailing 12-month par-weighted default rate decreased to 0.27% – the lowest-ever rate in high yield history – and we have observed similarly low levels of distressed debt in European high yield. However, we remain cognisant that the pace of growth in revenues and earnings before interest, taxes, depreciation and amortisation (EBITDA) is beginning to slow.
Strong corporate fundamentals across the credit spectrum
Markets have started to price in the risk that the Fed is behind the curve in tightening monetary policy. Fed tapering should be wrapped up by the end of March and at least four rate hikes are priced in for 2022, yet credit spreads have not moved materially. European and US IG spreads are only 3 basis points (bps) wider year to date, while their high yield counterparts sit just above and below the one-year averages of 316 bps and 333 bps, respectively. We do not anticipate a dramatic re-pricing of risk so long as rates rise in measured and orderly fashion. When considering past rate-hiking cycles, credit spread performance has been mixed: over the seven hiking cycles since 1980, four saw tighter spreads pre-hike while three saw wider spreads. However, post-hike performance has been skewed to the upside, with only one period of spread widening in the 12 months after the first hike. Thus, entering into a Fed hiking cycle in a steady growth environment has not been an originator of volatility in and of itself. However, this does not hold true if recessionary risks rise, which is best indicated by the shape of the treasury curve, with particular focus on the 2s10s curve inversion. While the 2s10s is flatter in this cycle than is typical at the onset of hiking cycles, it has not moved enough to warrant an imminent threat of recession. Moreover, markets will keep an eye on the possibility of quantitative tightening (QT) by the Fed. The outright shrinking of the balance sheet, which has for the past years acted as a backstop to spreads, could trigger a resurgence of volatility in US credit. The story is similar in Europe, where we anticipate the deceleration of the European Central Bank (ECB)’s Corporate Sector Purchase Programme (CSPP) and Pandemic Emergency Purchase Progamme (PEPP) corporate bond purchases.
Technical conditions are set to deteriorate in credit. While central bank purchases decelerate, we are simultaneously expecting heavy gross supply volumes this year. Despite the dramatic fall in bond yields witnessed since March 2020, inflows continued into US IG, particularly from retail investors. However, these flows have turned negative in recent weeks, a considerable change from the weekly flows of over USD 5 billion last year. In Europe, the ECB’s CSPP and PEPP have been buying a large share of the net supply and own roughly 27% of the eligible market. The paring back of this support, coupled with accelerating issuance in M&A and sustainable financing, creates a deteriorating technical backdrop. In high yield, the primary calendar has ramped up, following a brief hiatus triggered by the Omicron variant. We expect deal volumes to stay elevated as private equity funds have plenty of dry powder. Moreover, demand has been underwhelming across both European and US high yield markets in recent months, as witnessed by lacklustre retail flows. We believe more attractive valuations will be necessary to reignite excitement for high yield.
What does this mean for fixed income investors?
As we approach the beginning of the developed market tightening cycle, global portfolios should remain underweight duration in anticipation of higher yields. In addition, paring back exposure to risk assets while selectively owning high-quality credits is a reasonable strategy amid tightening financial conditions. Given the strength of corporate balance sheets, we anticipate tactically re-engaging with the broader asset class if, for example, risk premiums increase with intermittent bouts of volatility (short-term selloffs) or we witness greater discretion in the market’s pricing of credit risk.
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