8 April 2021
No credit left behind
With the recovery from the pandemic well underway, we believe defaults have peaked in credit markets, while even some of the most Covid-impacted credits have been able to access capital markets. The path looks clear for further spread tightening.
Fundamentals
Bottom-up corporate fundamentals are taking a back seat to the macro environment, which is looking increasingly supportive for high yield credit. In developed markets, at least, data continues to surprise to the upside. The US added nearly 1 million jobs in March, while the Institute for Supply Management’s services index reached the highest level since 1997, with the new order component hitting an all-time high of 67.2. European purchasing managers’ indices signal strong demand once economies reopen, but lockdown measures have been extended again in parts of the region. However, the vaccine rollout should start to accelerate in Europe this quarter. Investors’ optimism about the recovery is evident in their willingness to fund even the credits that have been most impacted by Covid; European airlines, airports, gaming companies, pubs and gyms have had no trouble accessing capital markets. As a result, we think we are likely to have already seen the peak in default rates, which fell from a recent high of 3.8% in February for European high yield corporates to 3.5% in March.
Quantitative valuations
While European HY spreads, at 311 basis points (bps), are trading below their five-year average, there is still a case to be made for a prolonged period of spread tightening. The tightest point in the last decade, 235 bps, was reached in October 2017, following a multi-year period of low volatility supported by the European Central Bank’s (ECB’s) quantitative easing programme. Today, the market exhibits higher average credit quality and we are arguably in another period of low dispersion amid more quantitative easing: March marked the eighth consecutive month without any euro HY bond sustaining a 10-point drop, the longest stretch since the start of the data series in 2004. Therefore, with spreads 76 bps off the tights, we could see further compression. While Covid-impacted sectors have already posted strong returns this year – 3.4% for retail, for example, compared with 1.8% for the broad European HY market and 0.9% for the defensive utilities sector – they still have more room to run. The retail sector is still trading 209 bps off its five-year tights, whereas the utilities sector is only 68 bps away. (Data as of 5 April 2021.)
European high yield spreads still have room to compress vs. their five-year tights
Source: ICE BofA Euro Developed Markets Non-Financial High Yield Constrained Index (HECM); data as of 5 April 2021. OAS: Option-adjusted spread.
Technicals
Although European HY retail funds have witnessed over EUR 1 billion of outflows this year (equating to 1.8% of AUM), the demand picture looks robust, as other buyers such as unconstrained fixed income funds, investment grade funds and the ECB have dipped into the space. New issuance has been strong in the first quarter of 2021, but we expect net supply to be lower than last year. In particular, the fallen angels trend of last year has reversed and we are now seeing net rising stars, as high yield issuers have been upgraded to investment grade.
What does this mean for fixed income investors?
The fundamental backdrop is supportive for high yield, which is emerging from the pandemic as a higher quality market as lower quality credits have fallen out of benchmarks following defaults and large high quality investment grade issuers have been downgraded to high yield (fallen angels). With dispersion extremely low, even the credits hit hardest by Covid are now performing well and still have room to tighten further. The demand for bonds with relatively higher yields and lower duration is pervasive. We therefore see high yield as attractive from both an income and total return perspective, as long as investors are vigilant about tail risks.
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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