Credit instruments should continue to outperform sovereigns, despite narrow spreads, until the cycle turns.
Slight preference for Investment Grade (IG) in the US, and banks still favoured over non-financial issuers.
High Yield (HY) preferred in the euro zone, given IG sensitivity to any rise in sovereign yields.
Emerging market (EM) debt benefits from improving macro backdrop and relatively attractive yields.
"We favour higher-rated HY borrowers, which will be less sensitive to tighter financial conditions."
Robust global growth and the resulting risk appetite have kept credit spreads in the developed world historically low, a continuation of the pattern observed in recent quarters. However, with underlying sovereign yields often negative after inflation, the asset class as a whole looks unattractive in absolute terms. Our cycle indicators suggest supportive conditions for corporate borrowers ahead, but tight spreads offer little scope for further narrowing.
United States. Within our Neutral rating on IG and HY, we retain a slight preference for the former. The credit cycle is maturing, but the elements that might trigger a correction are still not in place.
IG bond demand will be supported by improving corporate profitability and scarce issuance. We still highlight the advantages of better capital adequacy ratios, which underpin financials’ credit quality.
In recent quarters, we have seen rising corporate leverage in HY, lower interest coverage – a measure of a firm’s ability to meet its repayment obligations from operating profits – and weaker protection for buyers of new issues, suggesting that the cycle is well-advanced. As a result, we would favour higher-rated HY borrowers, which will be less sensitive to any tightening in financial conditions.
In coming months, the focus will be on the fiscal reform. Tax cuts would boost profitability and growth, and a less favourable tax treatment of debt would likely improve credit quality as companies seek alternative sources of capital. However, discussions have only just restarted and much time will pass before we can hope to see a signed deal.
Eurozone & emerging markets
"We would keep a slight preference for HY and corporate hybrids over IG."
Eurozone. The ECB continues to be an active participant in the IG corporate bond market – the proportion of monthly purchases made through its Corporate Sector Purchase Programme has risen since April’s cut in aggregate purchases from €80bn to €60bn.
A robust recovery in the eurozone is helping improve corporate balance sheets, and leverage ratios are generally lower than in the US. However, IG spreads have narrowed markedly and now offer little protection against a potential spike in sovereign yields.
We would keep a slight preference for HY and corporate hybrids over IG. The pick-up in available yields remains appealing in light of negative deposit rates and negative core sovereign real yields. In addition, subordinated financial debt is attractive, given the better health of the banking system and the moves to resolve the bad-loan issue in the periphery.
Sources: SGPB, Datastream, 05/10/2017. 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.