No time for complacency

September 12, 2024

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Strong technicals helped credit stay resilient during recent market turbulence, but investors should remain alert, writes Thomas Samson.

On August 5, investors had a shock as the fear gauge - the VIX index of volatility - spiked to a level not seen since the start of the global coronavirus pandemic in 2020.1 Yet while equity markets gyrated wildly, credit markets barely moved despite high levels of long-term correlation between high-yield bonds and equity markets. The question is why.

The first, and in our view most significant, reason is the supportive technical backdrop. Net supply in credit is limited as leveraged buyout (LBO) creation has been subdued and rising stars have reduced the investment universe, while inflows are at their highest levels in the last eight years. Investors in both European investment-grade and high-yield continue to reallocate to the asset class to take advantage of higher yields and a benign, rather than booming, economic backdrop.

The last time we saw inflows of this magnitude was in 2016, but that was during an extended period of quantitative easing, which pushed investors down the credit curve in a hunt for yield. Today, rates have normalised, offering an attractive alternative to risky investments.

Another factor specifically explaining the resilience of the European high-yield market is the growing share of bonds held by European collateralised loan obligations (CLOs) (Figure 2). CLO formation has been strong over the last two years, at a time when the universe of high-yield bonds has been shrinking due to ratings upgrades. This impact is most prevalent for B-rated senior-secured bonds that fit the CLO risk-reward equation and therefore helps bond price stability given the long-term investment horizon of most CLO managers.

In terms of how supportive technicals translate into investor behaviour, we can look at the relative performance of corporate hybrids (subordinated bonds from investment-grade issuers) (Fig. 3).  We believe this indicates investors are eager to access bonds with spread compression potential in exchange for subordination risk and higher volatility.

We are, however, also starting to see signs of complacency in the market. The bonds of companies who report disappointing earnings results appear to be only marginally, and briefly, impacted by the negative news flow, and prices recover quickly, despite a more uncertain outlook for those issuers. 

The strong technical means spreads remain tight and seem likely to remain tighter for longer given investor sentiment and the diminishing appeal of money-market funds. Yet while interest rates are again on a downward trajectory, questions remain over the growth picture, particularly after recent weaker-than-expected macroeconomic data on the manufacturing side.

As a result, we believe now is a good time to adjust credit portfolios by reducing the weight of more cyclical sectors and redeploying to defensive segments such as services and healthcare, as well as reducing exposure to corporate hybrids given their very strong recent outperformance. 

On an historic basis, September has traditionally been a weak month for credit in terms of total returns. And while the recent turbulence was mostly evident in equities, credit investors would also do well to remember that this is no time for complacency, especially without a central bank ‘put’ to fall back on.

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of September 2024 and may change without notice.

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Index Descriptions

HEC4 – The ICE BofA  BB-B Euro High Yield Constrained Index contains all securities in the ICE BofA  Euro High Yield Index (HE00) rated BB1 through B3, based on an average of Moody's, S&P and Fitch, but caps issuer exposure at 3%.

CBEI2LBS - The CS-BCI Euro is a market-capitalized weighted index that is calculated each trading day. It tracks only the liquid, tradable portion of the bank capital market. By only including liquid bonds, our index aims to provide accurate reliable and timely information on the bond markets, based on actual daily transactions and market making activities. In turn, making it easier to gauge current market trends and performance.

LEIE3BBS Index- Credit Suisse Liquid Eurobond Euro BBB Spread over Benchmark – the LEI Euro is calculated each trading day and is a market-capitalised weighted index. It tracks only the liquid, tradable portion of the Eurobond corporate bond market. By only including liquid bonds, our index aims to provide accurate, reliable and timely information on the bond markets, based on actual daily transactions and market making activities.

ECHITOBS Index – Credit Suisse European Corporate Hybrid Total Spread Over Benchmark – for more information on the CS European Hybrid Index, please visit https://plus.credit-Suisse.com/i/18y

LHYEBBBS Index – Credit Suisse Liquid European HY Eur BB Bucket Benchmark Spread

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