Credit markets pricing in a flawless recovery
We are seeing credit markets pricing in a best-case scenario for a global recovery as yields for corporate bonds continue to fall and credit spreads tighten. High-yield credit has been doing particularly well as positive vaccine and macroeconomic data accumulate. Yet, despite the optimistic outlook, we believe corporate bonds warrant a more cautious approach.
Across credit markets, spreads have continued to tighten to pre-covid levels as positive vaccine and macroeconomic data accumulate. But as corporate issuers take advantage of the current low interest-rate environment, investors are faced with the challenge of negative real yields and high leverage ratios. Desperate for yield, investors have been pushed into the lower tranches of the noninvestment-grade market, with the yield on bonds rated CCC and lower hitting all-time lows and spreads rarely so tight.
Investment-grade (IG) bond sector also faces issues. They have been suffering from rising government-bond yields, and duration has been slowly increasing as firms issue longer-dated debt to gain from the current low interest rate environment. Overall, we continue to favour the quality part of HY, which offers a higher spread cushion and a lower duration.
The sectors affected hardest by the pandemic, such as energy, retail and transportation, have also rallied, with yields falling to decade-low levels. As we expect the 10-year US Treasury yield to end the year close to current levels (our year-end forecast is 1.3%), we would add spread duration in defensive IG issuers with steep credit spread curves in such sectors. The US energy, retail and transportation sectors are cases in point. The energy sector could also be a major tailwind for the overall US HY market. We note that distress ratios for HY energy issuers have been falling recently.
Going forward, however, as inflation expectations mount and real yields fall deeper into negative territory, corporate bond portfolios could be challenged by even a mild, transitory inflation shock due to the thin spread cushion offered by recent new issues. Selectivity remains key in current conditions, as corporate bond markets are being priced for performance. As we see limited upside in the short to medium term as credit spreads continue to tighten for CCC and lower-rated bonds, we remain underweight US HY and neutral euro HY.