Valuations Fuel Challenges For Credit Market Sentiment: AnalysisBy
Compressed spreads and yields eroding corporate bond appeal
Investor sentiment negatively correlated to spread tightening
The persistent compression in corporate-bond spreads and the historic low level of government bond yields may leave investors questioning the appeal of corporate credit risk over the coming months, writes credit strategist Simon Ballard.
After central banks responded to the 2008-2009 financial crisis with ultra-low interest rates, and quantitative easing measures, many investors sought to offset this by allocating more capital to higher-yielding, riskier assets. The result was a sharp flattening of the credit quality curve as high-yield spread compression outpaced investment grade in the hunt for yield.
Corporate credit would seem to remain the asset class of choice for incremental yield while interest rates remain low and the macro outlook benign. But the aforementioned flattening of the quality curve has now left many questioning whether lower-rated assets are worth the extra risk, particularly when markets may turn volatile at any moment on account of a lengthening list of political and economic unknowns.
France is in the midst of presidential elections while the U.K. is starting divorce proceedings with the European Union, but not before holding its own general election in June. Perhaps the most significant near-term risk for credit market valuations will be the European Central Bank’s meeting on June 8. If the ECB alludes to monetary policy tapering, and eventual tightening, this could weaken one of the key pillars of risk appetite.
Global bond yields may have risen over the past year as reflation trades have been priced into the market, but from a longer-term historic perspective the underlying interest rate structure remains low and may still lack investor appeal. The 10-year bund yield has fallen around 400 basis points from before the global financial crisis, while the U.S. 10-year Treasury yield is currently around 270bps below its 2007 yield level.
Still, demand for corporate bonds remains robust for now, as reflected in primary and secondary European credit market volumes, as well as rising high yield ETF prices in the U.S. over the past 18 months. European syndicated primary issuance is 1.5 percent higher year-to-date than it was over the same period in 2016.
But the question going forward will be at what combination of rarefied spread and yield will corporate credit risk eventually fail to entice investment flows.
Key to risk-asset spread performance over the coming months will be the pace of any renewed rise in the underlying yield structure and the consequent availability of any higher-yielding investment alternatives across the fixed income or equity space.
A benign macro outlook for Europe suggests that the ECB may be limited in its ability to normalize interest rates over the coming quarters, which will help to maintain the status quo and potentially only further erode the appeal of the corporate credit asset class.