Deutsche Says Credit Cycle Not Turning Yet as Volatility Wanes

  • Relief seen amid reversal of VIX Index, AA rated bond spreads
  • High-yield bond spreads may move wider, strategists say

A turn of the credit cycle for the worse may not be as near as previously thought, according to Deutsche Bank AG credit strategists.

The strategists led by Oleg Melentyev point to two indicators that have retraced the risky levels they reached in late September. That still may not be enough to prevent a further selloff in high-yield debt, they wrote in a Nov. 6 client note.

At the end of September, stock volatility implied by the Chicago Board Options Exchange Volatility Index -- or VIX -- was surging, and investors were demanding around the most in three years to own AA rated corporate debt instead of U.S. Treasuries. Those,  and tightening monetary policy, were signals to the strategists that the credit-cycle turn was looming and the corporate default rate would tick up.

Since then the two measures have retreated, indicating the credit market is seeing some "relief" to those expectations, the Deutsche Bank strategists wrote.

Technicals in credit markets have finally turned "very strong" again, especially in high-yield, they wrote. The asset class delivered returns in October on the back of higher oil prices, slower issuance, "strong" coupons and inflows to bond funds, among other reasons, the strategists wrote.

Keeping the rally going in risky assets will be hard, they say. Not only will commodities prices need to increase, but emerging-market currencies and sovereign bond spreads will need to recover beyond their early August levels.

With the Federal Reserve poised to increase interest rates for the first time since 2006, that will likely make it "more difficult" to achieve such milestones as a stronger dollar weighs on commodities. That means the "next big move” in high-yield spreads "is likely to be wider,” they said.

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