25 November 2021
Looking through the volatility
The recent widening in credit spreads may offer an attractive entry point, with corporate and market fundamentals looking positive as we move into the final weeks of the year.
Fundamentals
Although the rates market has experienced recent volatility on the back of central bank news and inflation data, the credit market continues to look attractive on a fundamental basis. Investment grade corporate balance sheets continue to show strengthening EBITDA (earnings before interest, taxes, depreciation and amortisation) and revenue growth. As a result, leverage metrics continue to decline. Strong balance sheets and low leverage ratios have supported the credit market against the pressures of supply chain disruptions. Within high yield credit, the seemingly limitless supply of cheap liquidity combined with a strong earnings recovery has driven default rates to notable lows. In October, US default rates hit their lowest level in over a decade at 0.4%, while in Europe default rates hit 1%. Taking a closer look at the US, the percentage of distressed debt in the high yield market, which acts as a leading indicator for default rates, also remains near record lows. Looking ahead to 2022, pent-up demand from supply chain bottlenecks could translate into strong sales, while any stabilization of input prices should be sufficient for the restoration of profit margins. New Covid-19 lockdowns in Europe could threaten the strong fundamentals in the short-term but if 2020 has taught us anything, it’s that the credit market can weather the storm.
Distressed debt, currently at cycle lows, acts as a leading indicator to default rates
Source: Bloomberg, J.P. Morgan Asset Management; data as of 30 September 2021. HY = high yield.
Quantitative valuations
Even with the recent front-end volatility in the rates market, credit has generally held up quite well, with US and European corporate spreads widening by only 5 basis points (bps) and 12bps respectively month to date (as of 23 November 2021). Moving down the credit spectrum, similar widening has occurred in both the US and European high yield market. Some credit sectors remain well positioned to benefit from a post-lockdown surge in demand for commodities. The credit profiles of these companies have benefited from a lack of large capital commitments and increased cash flows, warranting tighter spreads. Furthermore, given pent-up demand and the continued limitless supply of funding, there is still room for spread compression versus pre-Covid levels.
Technicals
Market technicals look promising going into December. The expected drop in issuance, due to supply seasonality, could provide an opportunity for spread compression on the back of recent widening. Furthermore, despite the recent low returns in investment grade credit, we’ve seen strong inflows over the month as the funded status for US and UK pension funds have improved. US and European investment grade credit have witness inflows of over USD8 billion in the month to 19 November 2021. After navigating through the recent rates volatility, investors are focusing on the strong fundamental backdrop and the continued support from the European Central Bank (ECB) —providing a key backstop to the market. ECB gross purchases month-to-date (as of 19 November 2021) were at EUR 6.5 billion and with gross corporate purchases for 2022 expected to be at EUR 114 billion, it’s hard to be too bearish on spreads.
What does this mean for fixed income investors?
At the moment, recent volatility in front-end rates shouldn’t signal a de-risking event. Credit has fared relatively well over the past couple of weeks. With fundamentals remaining attractive and the low supply expected in December, the recent widening in credit spreads could provide an opportunity to add. Furthermore, even though the market’s focus has been on the ECB’s potential plan to wind down its asset purchase programme, net purchases are expected to remain positive and should be a tailwind for European credit. As we move into December, we think investors could potentially benefit from remaining underweight duration and overweight credit.
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
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