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Credit Chronicle: Where does a quarter of the categorical revaluation leave us in credit markets?

By on July 14, 2022 0

The damaging combination of rising government bond yields and widening credit spreads made for a very difficult quarter for bond investors – one of the weakest since the global financial crisis, according to Jeff Boswell, head of alternative credit.

July 14, 2022 The second quarter was particularly brutal for all bond investors, with a categorical repricing of risk leaving very little hiding place. Bond investors have suffered the double whammy of rising government bond yields alongside widening credit spreads, resulting in some of the largest negative quarterly returns since the global financial crisis (GFC).

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Credit markets are priced attractively

Jeff Boswell, head of alternative credit. Ninety-one: “While most credit markets started the year towards their cyclical strains in terms of spreads and yields, we have seen a categorical reassessment of risk across the board. To varying degrees, all major credit markets are now priced attractively from a spread perspective, and particularly attractive from a yield perspective,” as illustrated in the charts below, which look through a lens of historical percentiles (Figure 1)

Fig. 1. 10-year history of spreads and returns of the broad asset class (quintiles)

Credit markets

Source: Bloomberg, June 30, 2022. Govt. spread of OAS. US High Yield = BofA US High Yield (HUC0); European High Yield = BofA EUR High Yield (HPC0); US investment grade = BofA US investment grade (C0A0); European Investment Grade = BofA EUR Investment Grade (ER00); US loans = JLYMLLI index; European loans in EUR = JEYMLLI index. Note – European loan data is based on an 8 year history (considering data availability).

While the first quarter of 2022 was characterized by underperformance in higher quality (and interest rate sensitive) parts of the market, the theme for the second quarter was growing concerns among market participants about an impending downturn in the growth, with lower-rated credits underperforming as a result. . This fear of growth caused credit spreads to widen across all rating categories, however, lower rated credit (notably CCC) widened even more on a proportional basis. This decompression is best illustrated below, which shows the spread for CCC-rated US high yield bonds minus the spread for BB-rated US high yield bonds (Chart 2). At the start of the year, investors only received an additional 450 basis points of spread for holding a CCC-rated bond; this remuneration rose to 780 basis points on average.

Fig. 2. US High Yield CCC Spread minus US High Yield BB Spread YTD

Credit markets

Interestingly, while the decompression looks significant on a yearly basis, looking at it through a longer lens illustrates the potential for further decompression, should markets eventually price in a recession (Figure 3).

Fig. 3. US High Yield CCC spread minus US High Yield BB spread over the last 10 years, basis points

Credit markets

Following the general widening and decompression of market spreads in the second quarter, it is interesting to take stock of the current position of the various rating categories compared to their history (chart 4). For example, when looking at the US markets, it is evident that the price revision during the quarter has now left most categories reasonably balanced on a relative value basis when looking at one point valuations. of percentile view. Boswell continued: “However, percentiles aside, the absolute decline in lower-rated credit, given a more negative economic scenario and credit spreads drifting towards recessionary broads, is understandably much larger. This dynamic sums up the puzzle perfectly. currently facing credit investors, where spreads and yields look attractive from a historical perspective, but a highly uncertain economic outlook makes them reluctant to go too far from a credit risk perspective.”

Fig 4. Historical 10-year spreads and yields by rating band (quintiles)

Credit markets

So what is the solution to this riddle? Since yields are generally a great indicator of forward-looking returns for credit investors, history tells us that when spreads and yields have reset to these kinds of levels, forward-looking returns are usually very favourable. So, from an absolute valuation perspective, credit certainly looks more attractive than it has for a long time. However, economic uncertainty, inflationary headwinds, hawkish central banks and the ongoing war in Ukraine undoubtedly complicate the question of how to get the most out of this valuation reset.

Boswell concluded: “Given all of these uncertainties and the potential for further downside should a worst-case scenario materialize, we believe it is still important to remain highly selective in portfolio construction, with a top-quality orientation and a focus on minimizing default/cyclical risk However, the reset in valuations has been significant and this leads us to believe that now is the time for investors to take selective risk where they are paid to do so. favor of higher quality parts of the market would still allow participation in any market rally (quality usually rebounds first), but would also outperform on the downside in a worse scenario. , we believe that the selective addition of lower-rated credit securities will make more and more sense. nt essential in attempting to avoid any idiosyncratic individual credit risk”.

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About Ninety One

Ninety One is an independent and active global investment manager dedicated to delivering compelling results to its clients, managing £143.9 billion in assets (as of 31.03.22). Established in South Africa in 1991 as Investec Asset Management, the company began offering domestic investments in an emerging market. In 2020, almost three decades of organic growth later, the company spun off from the Investec group and became Ninety One. Today, the firm offers distinctive active strategies across equities, fixed income, multi-assets and alternatives to institutions, advisors and individual investors worldwide.

For more information, visit: www.ninetyone.com