Credit investors see recessions as a crisis. Defaults rise and the market prices in higher levels of default risk. But in 2015/16 the market expected a recession that didn’t materialize, and 2019 looks like it will be similarly defined by whether the dangers being highlighted in the market today are validated or whether they present an opportunity. Although the economic cycle does repeat, timing is key, and our view is that current valuations in credit may offer an attractive risk-adjusted opportunity. As in Samuel Beckett’s play, Godot is expected but doesn’t arrive, twice.
This year is ending with credit spreads widening and markets focused on the dangers of when the next economic slowdown will raise default rates and corporate leverage. At the start of 2018, expectations for global growth were high following U.S. fiscal reform, confidence returning to Europe and an acceleration of synchronized growth. But as the year progressed, macroeconomic concerns dampened the prospects for global growth. Trade-tariff negotiations, geopolitical headlines, concerns over higher U.S. rates, populist politics reducing fiscal discipline, and emerging market sovereign idiosyncratic events all contributed to the change in sentiment. Sellers of the asset class were also a technical factor over 2018. With yields historically low and credit spreads at recent tights in the first quarter, confidence in the returns from fixed income has been low.
Looking towards 2019, the risks are known, credible and well-debated—and arguably already priced in. The opportunity is that global growth stabilizes and Godot (the recession) does not arrive, again. In this scenario the increased systemic risk premium is unjustified as default rates stay low, company earnings continue to grow, higher yields stimulate demand for fixed income credit and confidence in the market increases liquidity.
The deep recession caused by the financial crisis in 2008 means this expansionary period is long by historical standards, but not unprecedented. Credit investors fear defaults and approach recession predictions the way the British approach discussions of the weather: It is always a topic of conversation, and any absence of rain today is thought to indicate a wet tomorrow.
Our base case is that many of the worst market fears will not materialize. We expect U.S. growth to be close to consensus at 2.5%, China to respond to any negative effects from trade tariffs with more stimulus, U.S. monetary policy not to cause a “hard landing,” and the trend toward populist politics to be diluted by checks and balances from both international rules and the markets. If this occurs, we would expect tighter credit spreads across all markets as the confirmation that Godot’s arrival is delayed yet again.
Increased U.S. dollar corporate debt and the expansion of the BBB-debt market represent additional areas of concern for credit investors, with some citing high leverage as a signal that markets are late in the expansionary phase of the business cycle. The counterargument is that low rates make interest costs both affordable and not excessive, and suggests we remain midcycle (see Display 1).
The absolute amount of debt that needs refinancing and ultimately to be repaid deserves broader discussion. While earnings continue to grow and free cash-flow generation remains strong, the levels of debt look reasonable, with companies growing into what are viewed as higher-risk capital structures. This scenario will depend on two broad factors: a macroeconomy that does not experience a hard landing and sector considerations that do not impact the current business model. We would also note that many companies do have strategic flexibility if current budgets are revised down. Companies have recently used both asset sales and dividend cuts to support debt reduction, highlighting both the ability and implementation of bondholder-friendly actions.
First, shareholder-friendly activity such as mergers and acquisitions (M&A) is normal in the expansionary phase of the business cycle. This activity needs funding and we look to own issuers when they come to the debt markets for financing (usually at a discount), believing that the interests of bondholders and equity holders are aligned in targeting debt reduction.
Second, technology disruption is occurring exponentially, and avoiding sectors and issuers most impacted will continue to be a challenge in 2019. Examples include the pace of change in the auto sector as we move from petrol/diesel to electric and then driverless, the impact of on-line shopping in the retail sector, blockchain allowing disintermediation in finance and the innovation around smart homes, all of which impact certain companies directly or indirectly.
Third, European financials continue to de-risk through selling assets and raising equity driven by regulators, which is positive for bondholders. We expect selecting the right sectors and issuers will be key in the coming years, as both generational behavioral trends and industry focus evolve.
But fundamentals will not be the only driver of returns in 2019: technicals and valuation will also be key factors. Credit 101 sees successful investing as the minimizing of defaults while maximizing the return from price volatility.
In investment grade, current credit valuations are attractive in the U.S. and Europe, based on both historical comparison, break-even analysis versus the risk-free asset, and when decomposed to reflect the expected probability of default. As the old saying goes, there are no good or bad investments, just good or bad valuations. European valuations are back to levels seen in Q1 2016 and U.S. spreads are at mid/late-2016 levels. The breakeven for owning credit at the end of October implies a breakeven spread widening over one year of approximately 36 basis points in EUR and 26 basis points in USD, a significant potential cushion for investors. At these levels, the risk-reward tradeoff of owning investment grade credit looks attractive, with a combination of carry and limited capital gains from spread tightening as our base case.
Technical drivers of credit should also be more supportive going forward. The expectations for supply and demand in 2019 will again be important for investors. Supply expectations suggest many issuers took advantage of low rates and tight spreads to lock in term funding in nonfinancials in 2018, although M&A can always create idiosyncratic supply. Bank supply will be driven by regulatory change, particularly in Europe, but while senior nonpreferred issuance is expected to be broadly unchanged, other parts of the capital structure will likely reduce. Demand was influenced in 2018 by the expanding cross-currency cost of hedging USD credit to other currencies with lower base rates. This is likely to remain a driver of demand in 2019. We also expect the market level to influence demand, with matching-liability portfolios looking to higher outright yields as a buying opportunity. In summary, while supply and demand are hard to predict, on balance we see a more positive technical outlook for 2019.
By region, Europe underperformed the U.S. in 2018, reflecting weaker economic health. We expect this to reverse in 2019, with sector and issuer selection helping determine performance. The avoidance of negative bondholder news will be key. We prefer regulated sectors like financials and utilities, where we see limited scope for businesses to increase their risk profiles.
In 2018, high yield saw some resilience, with support from limited supply and the demand for yield in a period of low defaults (see Display 2). We expect these themes to continue supporting the asset class, with defaults rising but staying low in a historical context. We are looking specifically for stability in equity markets and oil (a large sector in U.S. high yield) as necessary fundamental conditions for performance in 2019. Like investment grade, valuations have cheapened in 2018 and with the U.S. high-yield market offering yields over 7% and a spread in excess of +430 basis points, the risk/reward looks attractive. In addition, the low supply seen in 2018—down close to 40% in the U.S. year on year—is expected to continue in 2019, acting as an additional technical support.
Loans saw strong demand in 2018, supported by floating-rate debt with yield and credit protection through covenants. While making general statements can be misleading, we see weaker structural packages coupled with less-attractive valuations as the driver of underperformance in 2019, although the floating-rate resets will be the investors’ friend. If our base case is correct and defaults stay low, we would not anticipate negative performance in the sector, but as it outperformed other credit assets in 2018 we see more limited relative upside.
Looking at emerging market (EM) corporate debt, valuations look favorable relative to default expectations. We see the sharp correction of EM corporate spreads over 2018 as excessive given our assessment of credit fundamentals. Our confidence in EM credit is grounded in improving metrics (credit, management actions, etc.), supported by the behavior of EM corporates since the end of the global financial crisis. These improvements are best illustrated in default expectations, which now look likely to end the year well below the 2.5% forecast we set at the beginning of the year. This is in spite of the rise in idiosyncratic negative developments in countries such as Argentina and Turkey.
Looking ahead to 2019, we view the spread widening of EM high yield as particularly noteworthy given expectations that default rates in EM will likely remain low and in-line with developed high yield next year. In investment grade credit, we also believe the weakness in spreads is somewhat counterintuitive given fundamental improvements in EM credit quality, which we expect to translate into upgrades outpacing downgrades over the coming 12 to 18 months.
2019 will be defined by expectations of when the expansionary period ends. Our base case scenario is that a recession is not imminent—hence we see value in credit spreads. Sector and issuer selection will be key decisions in 2019 as technology and behavioral change are both fast-moving and disruptive for many traditional industry business models. While some commentators view the credit markets as being in a “crisis,” we see some dangers that are known and priced in, as well as opportunities for carry and limited capital gains through both owning the asset class and active positioning.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the portfolio may generate less income. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation, and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
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