Default is Credit

The strong performance from credit markets this year receives limited attention. However, the reality is that default risk remains very low and credit risk premiums generally compensate investors for taking risk. This makes certain strategies in fixed income look attractive. Short-duration credit strategies should outperform low cash returns while credit focussed active bond approaches have the ability to add credit risk should there be a macro driven sell-off. This has usually been a winning strategy. The corporate earnings cycle needs to be watched as does the macro data but today credit retains significant attractions in a bond world that admittedly will likely have lower overall returns.  

Q3 delivered lower yields

During the third quarter the share of bonds in the European broad market index that traded with a negative yield increased from 48% to 61%. The share of the index trading with a yield below the European Central Bank’s (ECB) deposit rate at the start of the quarter was 22% and is now 31% - relative to the pre-12th September deposit rate - and the same 22% relative to the new deposit rate of -0.5%. The median yield on the index has dropped by 10 basis points (bps) over the quarter and the standard deviation of yields has declined. So, there are more negatively yielding assets, the average yield is lower, and the distribution of yields in the universe has become more compressed. The market cap-weighted index yield fell from 0.2% to zero over the quarter. All of this amounted to an index total return of 3.396% (to September 26th) the best quarterly performance since Q3 2012 (“whatever it takes”). The message is that bond beta is all about expected and actual changes in monetary policy. The ECB was expected to deliver additional monetary stimulus and did.

Lower returns but credit still ok

While the backward-looking story is good, the prospects for getting additional beta (let alone alpha) at current yield levels must be constrained. With a quarter of the market yielding less than the deposit rate and the recent tiering of deposit rates for banks reducing the need to charge customers for their deposits, cash has become relatively more attractive to a lot of fixed income in Europe. If you can hold cash at 0% you are doing better than you could do in more than half of the European bond market. This means that bond exposure should be geared more towards credit and peripheral government bonds where more positive yields can be found - clearly at the expensive of a lower overall credit rating than the market. The European corporate bond market still has an average spread relative to government bonds of 111bps and this has remained more or less unchanged on the quarter (although using asset swaps to measure credit risk, the quarter saw an increase in spreads from 63bps to 80bps). The credit market has outperformed government bonds all year and did so by 50bps in Q3. Year-to-date, the European credit market has had its best excess performance since 2012. For choice, we see this continuing with the combination of investors’ need for yield and the re-booting of the ECB’s asset purchase programmes being beneficial to the performance of the credit market. Don’t be put off by a lot of negative yields in the index.

US market more attractive

Having said that, we are talking pitiful absolute returns, as you would expect when the risk-free rates in the Euro Area is now -0.5%. In the US market, credit has not outperformed in Q3, but the total return has been strong, at 3.7% in Q3 and at 13.6% year-to-date. Even accounting for foreign exchange hedging costs, European investors would have been better off in the US market (from a beta, total return point of view) in 2019 (the euro hedged total return for the US credit market has been 11.4% compared to 7.6% for the Euro credit market). Yields and spreads remain higher in the US market than in Europe so total return expectations seem more positive. Given that bond market beta returns are driven by interest rate expectations, we suspect that the market will remain wedded to the belief that the Federal Reserve (Fed) will cut rates again this year and this will help US bonds. The yield on the US corporate index is currently just under 3%. It reached a low of 2.62% in 2013. There is still potential for better returns in the US compared to European credit markets.

Credit strategies

While accepting that total returns in fixed income are likely to trend lower after the very strong performance so far this year, the question we ask is why would you not invest in corporate credit if you have to be in bonds? Yes, you can take a directional view on interest rates and that tends to lead to playing the yield curve in government bonds (which maybe should be seen as a separate strategy or an overlay), but corporate bonds will provide additional yield relative to government bonds, and in the investment world this happens with very little risk of default. According to the most recent Standard and Poor’s Global Default Study (April 2019), since 2010 there have only been two investment grade defaults and in most years, there were none. So, unless you are very unlucky, an investment grade portfolio should be money good all the time. This is a particularly important support for short-duration credit bond funds which mostly operate on a buy and hold. When cash returns are so low, the little extra return from credit helps. And for these kinds of strategies the risk-return consideration allows concentration on the lower rated parts of the investment grade market. The key risk is that companies get downgraded to high yield where the default risk increases. But actively managed funds (i.e. not 100% buy and hold) can mitigate the risks of this.

Low defaults 

Ratings do play a role in more active funds that try to maximise total return and are not constrained to the short-end of the curve. While the default risk holds true, there will be mark to market risk depending on the credit rating bucket and the machinations of the economic cycle. Triple-B rated bonds will be more volatile in their performance through their life than double-A rated because of the higher intrinsic credit risk and the tendency of spreads to widen during economic downturns. But most of them don’t default. So, it generally pays to buy credit when spreads do widen. Any Brexit related shock to the UK market that pushes spreads on the UK corporate bond index towards 200bps (currently at 150bps) should be seen as a buying opportunity. Credit ratings and access to the capital markets are super important to companies and management will do their very best, where they can, to avoid doing things that result in a downgrade from a credit risk level they feel comfortable with. Non-fixed income people that go on about credit markets being in a bubble but at the same time are positive on equities miss the fact that if there is a rise in defaults it is also likely to mean a collapse in corporate earnings and a de-rating of equity valuations. Overall, credit investors get rewarded for holding corporate bond risk. Since 2000, there have only been three years in which the global investment grade credit market has delivered negative excess returns (i.e. underperformed government bonds).  Again, smart investors can separate the duration view form the credit view. At times there is negative correlation, but this year has shown that having longer duration and an overweight to credit has been a winning strategy.

Cycle weaker but not awful

If mark to market volatility in credit is an investor’s major concern then having some view on the health of the corporate sector is important. We know rates are going to remain low everywhere, which helps funding costs and leverage. Recent issuance activity has been fairly well received in most markets, so demand is clearly still strong for credit. At the macro level the growth slowdown has been factored in and recent data has not suggested anything new about the severity of the economic slowdown. I updated my spreadsheet for corporate earnings expectations this week and you might also say that a lot of weakness has already been priced in. The IBES consensus 12-month forward growth rate for the S&P500 is for growth of around 8.6%, which is slightly up on forecasts from earlier this year and contrasts with trailing EPS growth of just under 6%. For Europe, the picture is similar, but the trailing number has been much weaker reflecting the greater sensitivity of the European economy to the global trade war. Expectations are weaker for the UK market (Brexit) and actual EPS growth has softened considerably since last year. In total, the trend is negative, but the absolute is not overly uncomfortable for credit investors at this stage. Hedged with some long duration exposure, there should be some protection against a deterioration in corporate sentiment.

High yield 

Even in high yield there is no sign of the default rate picking up. For 2018 the default rate was 2.1% and has only once been above 4% since 2010. A well-diversified high yield strategy benefits from all the arguments for investment grade above except of course that the default rate is higher, the sensitivity to the cycle is higher but the potential income return is also higher. Global high yield has underperformed government bonds in six years since 2000 but in positive years the returns are very strong. The long-term performance of high yield is very good with the global index delivering 280% across US dollar denominated accumulated total returns since the end of 1999 compared to 180% for investment grade and 123% for global government bonds. Don’t underestimate the combination of compounding the credit risk premium which, most of the time, overly compensates for risk.    

Today’s outlook

Bring that all to today. Credit markets offer decent relative value given where spreads are. The global cycle is soft but not in recession and there are significant upside risks if things work out. Interest rates remain low and monetary policy is likely to be supportive to corporates. Investors need yield and there is a surfeit of global savings that will be attracted to corporate bonds in the absence of any significant upturn in fiscal expenditure and borrowing. Credit may not be super exciting relative to equity markets, but it’s hard to see a credit bear market anytime soon. For those investors that can, the structured credit markets – ABS and CLOS – provide even more spread to compensate for a little less liquidity than in core bonds. Unless the macro environment really turns down, in aggregate credit markets should not be under-invested in, and in most cases, particularly in Europe, should provide a better investment than government bonds or cash.

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