Five Credit Views in Five Charts Q3 2022

By Darren Toner, Senior Portfolio Manager
(High Yield, Financials and Investment Grade)

September 2022

Rising geopolitical tensions, a global energy crisis, slowing economic growth and central banks’ commitment to fight stickier high inflation continue to weigh on Credit and Equity markets. Here are five trends that we are observing in financial markets.

1. Credit appears cheap relative to Equities

When we compare the risk premium above the risk-free rate between Equity and Credit markets, we see a different story: US Equity risk premia is currently trading at its 1st percentile since 2011, meaning that equity investments are looking expensive. On the other hand, Credit and US High Yield (HY) are currently in the 68th percentile, making Credit look relatively attractive. The difference signals that Equity is pricing in a well-handled soft landing, whilst Credit suggests the tightening of monetary policy will lead to a recession and a material increase in defaults. Although nobody really knows whether a recession can be avoided, our analysis suggests that Credit should outperform Equities in either scenario given the valuation gap.

Chart 1: Credit says recession, Equities say soft-landing

Difference HY spread - Equities risk premium (basis points)

2. European Financials versus Corporates - Technicals provide opportunity

European banks have built a strong position, with robust capital levels combined with a tailwind from rising rates, which typically increase profitability. This leads us to having an overweight sector bias. Contrastingly, European corporate bonds face multiple headwinds despite also coming from a strong fundamental position, including the effects of the energy crisis, record high inflation, consumer weakness, windfall taxes and the end of the European Central Bank’s (ECB) bond-buying programme. However, and due to certain technicals in Financials, such as higher supply, we have seen European banks’ spreads dramatically underperform other corporates, as seen in Chart 2. For example, in European Financials we saw in August €63.5bn issued, or 2.6 times more than in August 2021 and c. €28bn higher than any other August in the last 20 years. Issuance is likely to slow significantly from here, since banks are now ahead of their issuance plans. Whilst European Financials will also face some headwinds fundamentally, they provide an excellent relative value opportunity both in Senior and Subordinated levels relative to their corporate equivalents.

Chart 2: Financial spreads have widened more than corporate spreads

3. Credit spreads are attractive, but yields are even more so

With the evolving macro backdrop, spreads have widened over the last year, providing attractive entry points relative to historic levels. As seen in Chart 3, the yields available are substantially higher than they were last year. This has been driven by a combination of rising government bond yields globally and the aforementioned spread widening in Credit. In fact, even on a look back to 2011, the yield offered by Credit is at the 90-99th percentile across both Investment Grade (IG) and HY markets. Both IG and HY yields are now attractive relative to Equities on a risk-adjusted basis, providing a level of income that should help dampen market volatility.

Chart 3: Credit yields have risen to attractive yield and percentile levels

4. European inflation more of an issue than in the US – market says

Inflation has been a hot topic for markets and may become even more so: markets are pricing in a sharp drop in inflation over the next 12 months, particularly in the US, where it is expected to fall close to the central bank’s 2% target, whilst in the Eurozone this may take two years and substantially longer in the UK, as seen in Chart 4. Europe may see more persistent inflation than we have seen historically because of its current weak currency, which makes imports more expensive, and also because of the region’s open economy and reliance on global energy sources (both issues that the US does not have). As a result, European investors are demanding an additional premium in Credit, which has taken European IG and HY spreads to trade 40 basis points (bps) and +75bps, respectively, wider than their US counterparts.

Chart 4: Forward inflation expected to return to central bank targets: markets say when

5. Credit ratings – dispersion is rising, creating opportunity

In our last edition, we highlighted increasing dispersion within sectors as a source of opportunity; now, and given the ongoing volatility, we see a similar trend impacting rating buckets. In US Credit markets, for instance, and over the past three months, the spread difference between IG and HY corporate bonds has traded from the 90th percentile to the 10th percentile, and back to the 72nd percentile of their relationship since 2011. In July and early August, much of this volatility was driven by short covering in the US High Yield ETF, which as a result traded at high premiums and in turn forced bond prices higher; at the same time, IG spreads widened on ample supply. Trading the ratios of these rating groups can provide outperformance: for example, switching from HY to IG in mid-August would have protected returns by 2.3%, as investors would have sold HY at high prices to buy IG at attractive levels.

Chart 5: IG vs HY: wider spread and percentile difference

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