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Everyone is in love with credit risk! The high yield credit index returned 13.94% and the investment grade index returned 8.14%, better than the S&P 500 return of 6.74% for the year-to-date that ended in mid-September.
Why such a good showing? Of course the rally in treasuries helped, but we have also seen serious spread compression in the corporate credit markets since the wides of the first quarter. There is just an insatiable hunger for yield as central banks keep rates low, goose demand by purchasing investment grade corporate bonds and keep liquidity, risk appetite and economic outlooks strong.
High yield bond spreads are driven by default expectations, which usually peak during recessions. At this time, the high yield market is only pricing into spreads a 1% chance of recession over the next year, as calculated by market analysts. However, economists peg the risk of recession at 20%. Clearly the markets are pricing in a too rosy economic outlook, in our opinion. We see some of the same overly rosy economic expectations in the investment grade markets, although to a lesser extent than in HY.
At SNW, we know central banks can keep risk appetites alive for too long, and we know prices are being driven higher by much too optimistic economic outlooks. Acknowledging both of these truths, we prefer to take corporate risk in the front end of the curve to reduce the risk from spread widening and company specific credit events. And we prefer high quality financials, where fundamentals have improved since the credit crisis and continue to benefit from tighter regulation.
We don’t know how long the great credit returns will continue, but we are preparing for the time when these trends will reverse.
Source: Financial Times, Bank of America Merrill Lynch