Despite a disappointing Q1, we still expect credit to outperform sovereign bonds slightly in 2018.
In the US, we still prefer Investment Grade (IG) to High Yield bonds (HY) and banks to non-financial corporate bonds.
In the eurozone, we favour subordinated financial debt and corporate hybrids, and prefer HY to IG.
In the UK, we expect credit to do better than sovereign bonds given the additional carry.
"We still prefer IG bonds to HY and banks to non-financial corporate debt"
After a strong start to the year with further spread compression and heavy issuance, credit markets have been hit by risk aversion. Spreads have widened back to levels last seen in Q3 2017 and last year’s supports (economic recovery, abundant liquidity, accommodative monetary policies) are fading. Corporate metrics remain favourable with solid earnings growth and expectations for low default rates. However, the overall environment is turning less supportive.
United States. Spread widening has been more pronounced for IG bonds than HY instruments, mostly because of heavy issuance and weaker risk appetite.
Also, complacent investors have accepted weaker investor protection clauses, known as covenants. A new wave of mergers and acquisitions could worsen credit metrics and higher US rates are driving sovereign bond yields up, making diversification into corporate bonds a less compelling play for institutional investors.
However, credit fundamentals remain solid overall. Strong earnings growth has kept leverage ratios under control although they have begun to creep up recently.
We expect spreads to stabilize before ebbing again thanks to a favourable economic context, lower issuance and positive earnings momentum.
Eurozone & UK
"Corporate bonds should outperform sovereign bonds"
Eurozone. Despite heavy buying from the ECB, corporate bonds have not resisted the market turmoil. Under upward pressure from US yields and trade war concerns, high yield spreads have widened back to levels last seen in spring 2017, while IG spreads have increased more moderately. We now expect spreads to narrow again.
The credit market will lose some of its support as the ECB starts reducing its asset purchases. However, easy funding, stronger growth and mild corporate leverage should all help default rates move even further below their historical average. Against this backdrop, we continue to favour subordinated financial debt and corporate hybrids which are likely to benefit from more robust growth and a steeper yield curve.
UK. The first quarter has seen spreads widen sharply. The market turmoil worldwide means US and eurozone market trends have reflected in UK corporate bonds, just as for Gilts. However, UK credit markets could be reassured by the recent efforts to achieve a soft Brexit and expectations for more stable growth. Also, the additional carry will help UK credit to outperform sovereign bonds.
Sources: SGPB, Bloomberg, Datastream, 29/03/2018. Past performance should not be seen as an indication of future performance. Investments may be subject to market fluctuations, and the price and value of investments and the income derived from them can go down as well as up. Your capital may be at risk and you may not get back the amount you invest.