We still prefer credit to government bonds despite tight spreads. A major correction is unlikely in coming months and the extra carry – i.e. the additional interest which accrues over time – justifies holding on.
In the US, we still prefer investment grade bonds to high yield and banks to non-financial corporate bonds.
In the eurozone, we turn more cautious on investment grade bonds while maintaining a preference for subordinated financial debt and corporate hybrids.
In the UK, we expect credit to outperform sovereign bonds thanks to the additional carry
"We still prefer investment grade bonds to high yield and banks to non-financial corporate debt"
Thanks to a benign economic backdrop, abundant liquidity and ultra-accommodative monetary policies, credit spreads have tightened further in H1, continuing last year’s trend.
However, this also means that corporate yields are now less attractive. So, while credit fundamentals remain broadly robust – despite some weakness in the US – current valuations limit the scope for further tightening.
United States. Leverage ratios remain high, although they have eased somewhat thanks to stronger earnings and slower debt issuance. Interest coverage ratios, which measure a company’s ability to meet interest expenses from operating profits, have been weakening for a while – adding to signs of declining corporate health. These weak fundamentals bolster our conviction that the US credit cycle is maturing.
However, the triggers for a correction are still not in place: the US economy will continue to recover – even without additional fiscal measures – and default rates are unlikely to rise sharply. We still prefer investment grade bonds to high yield instruments (for valuation reasons) and banks to non-financial corporate bonds as they show better fundamentals.
Eurozone & UK
"Tighter eurozone corporate spreads have reduced the appeal of credit versus sovereigns"
Eurozone. Faster earnings growth, limited debt issuance, better interest coverage ratios, coupled with a sustained economic recovery and very accommodative monetary policies – all these factors will keep default rates low for the foreseeable future. Moreover, the ECB’s Corporate Sector Purchase Programme was not cut to the same extent as for government bonds when monthly purchases were clipped from €80bn to €60bn in April. This is no surprise as the ECB has refocused from covered bonds and ABS to corporate bonds. With demand strong and supply limited, credit markets are well underpinned. However, the ensuing squeeze in Investment Grade and High Yield spreads has reduced the appeal of credit versus sovereign bonds. We would prefer subordinated financial debt and corporate hybrids which are more likely to benefit from stronger growth and a steeper yield curve.
UK. The much-feared end to corporate bond purchases did not ruffle the market. Investors worried weaker public demand might translate into wider spreads, especially with institutions trying to reduce exposure to corporate bonds. However, investment grade spreads did not budge, signalling that abundant liquidity worldwide has held sway over weaker central bank demand. We expect spreads to trade in line with eurozone and US equivalents, and that carry will help UK credit to outperform sovereigns..
Sources: SGPB, Bloomberg (05/07/2017). OAS = option-adjusted spread. 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.