Are credit spreads heading structurally lower?
In light of another strong week for credit, Hilary Blandy, fund manager, fixed income, discusses the trend towards structurally lower default rates and the possible implications this could have for credit spread ranges in future.
It has been another strong week for credit. Spreads remain at very tight levels , with the spread between ratings segments having compressed and low levels of dispersion across the market. The low-hanging fruit that investors were able to pick at the start of the year is now long gone and it is more challenging to find value in the market.
In addition, the primary market has been very busy with a big pick-up in refinancing activity across the board and especially in Covid-impacted sectors, from issuers who would have come to market last year. We have also seen some opportunistic issuance as companies seek to lock in historically low coupons and an increase in M&A related financing activity. All this issuance has been generally well-absorbed into the market, although we did see spreads widen slightly in response. It feels to me that much of this issuance is priced to perfection, with limited upside and as a team we’re being very selective about what we participate in and disciplined on pricing.
Focusing in on spread levels, if you go back to the early days of high yield in the late 1990s, on occasions when spreads have reached the tight levels they are at currently they’ve usually been quick to retrace. One of the troughs that did go lower than we are now was in 2007, when spreads in Europe were as much as 100bps tighter than they are now. Set against this, economies are booming, governments are tearing up the rule book on fiscal spending and central banks remain extremely reluctant to raise rates. So it is hardly surprising that spreads are tight.
Default rates also play their part and have been much lower than expected. Analysis from Deutsche Bank shows that over the last 40 years default rates have been moving structurally lower. In the US, default rates topped out at about 12% during crises such as in the early 1990s, the dotcom bubble and the global financial crises (GFC). By contrast, the Covid peak was 8%. Looking through the cycle, default rates of around 4% used to be fairly typical, but that too has shifted to a baseline range of about 0%-2%.
Some of this change in default rates – which began to take hold in the early 2000s – is down to explicit factors like loans, bailouts and interventions and some is down to implicit factors like quantitative easing and low interest rates. If you plot the default rate versus single-B spreads over time, however, you will see that spreads haven’t adjusted to an environment of structurally lower default rates.
Deutsche’s explanation for this is liquidity, and certainly in credit we can see that liquidity is much worse now than it was 15 years ago, so its natural for spreads to include a liquidity risk premium. But post the GFC, we’ve seen central banks step into the corporate bond markets. The ECB have been doing it for years, and last year we saw the Fed start to buy corporate bonds as well. One might argue, that since central banks are now providing credit markets with liquidity during times of stress, it is open to debate how much liquidity risk premium is appropriate. If a lower premium applies, then one would expect credit spreads to move to a lower structural range.
The lion roars: house prices point to UK recovery
Tim Service, fund manager, believes that the strong surge in UK house prices this year is a good omen for the wider economy.
UK house prices have been rising at their fastest rate since the great financial crisis of 2008. Unusually for the UK house market, the picture seems to be regionally balanced, with most regions strong. Apartments in cities may be lagging behind a little, perhaps reflecting people’s desire to achieve a better quality of life closer to the countryside. Prices for second-hand houses are outstripping those of new builds, while there has been a large increase in the volume of sales.
The stamp duty holiday, introduced by chancellor Rishi Sunak in July 2020, and expiring this week, has helped, but is not the main reason for the price rise, in my view. The strength of international house prices supports my view. Survey data points to a continued strength of demand by UK consumers to move house after the end of the stamp duty holiday.
This is a good sign for economic recovery in general. Animal spirits are returning. People’s willingness to buy houses is a sign they want to put COVID behind them get on with their lives. It shows that UK consumers have confidence in the future, including a belief that they will keep their jobs. Nor is there any reluctance on the part of banks to lend. Mortgage lenders are taking the opportunity to expand their businesses and have tempered some of the caution characteristic of their approach during the past decade. 90% loan to value mortgages are reasonably priced.
Rather than being a short-term inflation blip, the house price recovery points to sustained, multi-year demand, in my view.
India’s road to economic recovery
Aimee Truesdale, assistant fund manager for Jupiter’s India strategy, explains how the Covid-19 situation is improving in India, and why she is confident about the country’s economic recovery.
Unmistakably, India has been hit hard by the Covid-19 pandemic, where we’ve tragically seen almost 400,000 deaths and over 30m cases. However, since India’s second wave peaked in May, it has been encouraging to see infection rates and deaths coming down quickly.
Furthermore, over 300m doses of vaccines have been administered so far, with around 30% of adults having received at least one dose. While it’s fair to say the country is still some way off herd immunity, the pace of the vaccine rollout is accelerating, with around 5m vaccines being given every day, and with plans to ramp up to around 8m a day. The government is currently targeting for all adults to be vaccinated by the end of the year – while we think that’s a bit ambitious, we believe early next year should be realistic, and it is still possible that herd immunity could be reached before then because many people have already had the virus. For example, a recent study in Mumbai found that over 50% of children already had antibodies.
On a company level, many businesses were able to use their learnings from the first wave to adapt very quickly in the second wave. Therefore, we think that the negative impact to the economy will be considerably shorter and shallower than the first wave. For the full year to 31 March 2021 (which has been a very protracted earnings season due to Covid), many companies actually posted better-than-expected results, with a weighted average EPS growth for the market of around 15%. Furthermore, global ratings agencies expect around 9.5% GDP growth in India for this financial year (to 31 March 2022).
We believe one of the positives that should come from the pandemic is the renewed focus on India’s healthcare infrastructure. We have significant exposure to the sector, where we can see there’s clear need for investment, and there’s a lot of change and consolidation happening in the space. Elsewhere, we are also relatively bullish on the domestic travel sector, where we have exposure to airlines and hotel operators. India’s borders are still closed, and we believe they’ll stay closed for a while, but we believe there’ll be strong demand from domestic consumers looking for staycations, which is something we also saw after the first wave. Even before Covid, the industry was capacity constrained, and we expect that the pandemic could precipitate some consolidation within the space. We choose to focus on companies that have strong balance sheets and good quality assets, which we believe will be the first to benefit as appetite for domestic travel returns.
To conclude, we are feeling confident about India’s economic recovery, given the improving Covid picture and resilient company results so far. We’re able to identify many attractive companies that we believe will be able to deliver strong earnings growth, and we continue to find names that are trading at attractive valuation multiples compared to the overall market.
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