- WisdomTree – If Focusing on Fundamentals, Buy the Dip in IG Credit
After making fresh cycle lows in early February, IG credit1 spreads have widened by approximately 24 basis points (bps) over the last two months. In our view, if this was the beginning of the end for this credit cycle, we would have expected to see this move confirmed by a similar shift in high-yield (HY) credit2 spreads. Over long periods of time, IG and HY credit spreads tend to have a fairly strong correlation because credit spreads serve as a barometer of risk. When the economy is healthy, corporate bonds pose less risk of being downgraded or falling into distress. When the credit cycle is turning, spreads widen as investors sell out of risky debt. Curiously, the most recent move appears to have affected IG more than HY.
- Citi Private Bank – Overweight US high yield despite challenging outlook
With long-term US Treasury rates stabilizing, US investment-grade (IG) corporates were able to post their first positive month of 2018. Albeit small, IG corporate benchmarks gained 10 basis points (bp) in March, bringing year to date returns to -1.9%. Of course, the best performing components of IG last month had been the areas beaten down the most from the rise in US rates (i.e., long duration and AA/A rated issuers). While rising US yields are largely responsible for IG underperformance this year, weakness can also be attributable to rising US-China trade tensions. With the rise of global risk aversion and equity volatility, US corporate benchmark spreads have widened 25bp to 110bp. This is the largest move wider in benchmark spreads since the oil recession in 2016. Changing supply dynamics and rising hedging costs have also played a role. Though IG supply started the year slow, recent weekly volumes have been in line with 2017’s record pace. More notable has been the pick-up of issuance in longer-dated maturities, which has increased 60% versus the same period last year. Moreover, the demand from European investors has slowed, as the rising cost to hedge USD has reduced the yield pick-up from buying US corporates. This waning demand has exacerbated the underperformance, in our view.
Summary
The stabilization of Treasury yields has enticed some investors back into credit markets. After a long absence, net inflows have returned for pure U.S. corporate bond ETFs. The recent bullish breakout by long term Treasuries suggests several weeks of consolidation ahead, making an opportunistic approach to credit exposure attractive. Leveraged loans have offered superior risk-adjusted returns in 2018 but may face headwinds if yields and implied volatility trend lower.
Comment
We first noted U.S. ETF investors shying away from pure corporate bond exposure in late January. Only two weeks later the volatility repricing prompted record outflows from investment grade and high yield corporate bond funds. Sentiment appears to be turning after the 10-year Treasury yield fell short of the key 3% threshold.
The chart below shows the four-week moving average of net flows for all U.S. corporate bond ETFs by type. Pure investment grade (light orange) and high yield (dark orange) funds have seen net flows turn positive this month.
A post in late February estimated the path of U.S. 10-year Treasury note yields under a variety of central bank stimulus scenarios. None of the scenarios, even those allowing for additional balance sheet expansion by the ECB, saw 10-year yields sustain a rise above 3%. We commented in the February post:
All scenarios had U.S. 10-year yields grazing 3.0% to start 2018 before declining yet again. The depth of a drop in yields becomes more exacerbated in the event U.S. and Eurozone economic data growth falls back to one-year averages or below.
A continued period of above-average economic growth would make any rebound by U.S. Treasuries less severe. But, all scenarios indicate 3.0% could be a difficult threshold to break in 2018. A deviation from these forecasts (i.e. break above 3.0%) would indicate a new latent factor is dominating investor reactions.
Long-term Treasury yields have followed the program so far, sustaining their break below range lows. Similar bullish breakouts have seen Treasury yields trade sideways to lower over the next 2 months. Credit market investors appear to be positioning for this outcome, taking advantage of wider spreads and higher yields.
Some new trends are developing in credit market exposure. Most investors still expect rising short term interest rates as the Fed keeps tightening. Steadily rising LIBOR and very strong risk-adjusted performance is luring investors into bank loan ETFs. The chart below shows the 4-week average of net flows for U.S. leveraged loan funds.
The Citi piece above suggests the outlook will continue to favor leveraged loan exposure:
US variable rate high yield bank loans also offer an attractive complement to HY bonds. LIBOR rates are expected to rise over the next 12 months, which should continue to fuel demand for floating-rate assets. Repricing and refinancing risks remain elevated, with roughly 75% of the loan universe trading above par. However, with average LIBOR-spreads around +375bp, this implies an all-in yield around 6.0%, which is fairly comparable with US HY bonds. More important, during bouts of risk aversion, bank loans are much less volatile
We’ve highlighted the potential for leveraged loans to outperform in a rising rate, rising volatility environment since January. Leveraged loan outperformance over high yield bonds depends both on rising interest rates, which adjustable rate loans capitalize on, and rising implied volatility, which makes this option more valuable. The Citi piece makes another point that bank loans have delivered superior risk-adjusted returns as volatility roiled other markets.
The last chart shows 1-year reward to risk ratios (average daily return / standard deviation of returns) for Bloomberg Barclays total return indices for U.S. investment-grade, high yield and leveraged loans. The leveraged loan index has offered very strong risk adjusted returns since 2017, even as high yield and investment grade tumbled in early February. Stable-to-lower Treasury yields and diminished volatility would dampen performance. The big risk for leveraged loan performance is a sudden fall in Treasury yields that sees rates adjust lower.
Conclusion
Stabilization in Treasury yields has credit market investors boosting their exposure again. Investment grade, high yield and leveraged loan funds are all seeing inflows as investors position for rising short term rates, stable-to-lower longer term Treasury yields and persistent volatility. Leveraged loans have delivered superior risk-adjusted returns but may face headwinds if we see volatility fall and Treasury yields move lower.