Ten charts that show there's value in credit

The sharp selloff in corporate bonds has created value in a number of areas, leaving the asset class looking well-placed.

01/04/2022
value

Authors

Julien Houdain
Head of Global Unconstrained Fixed Income
Rajeev Shah
Global Credit Strategist
Martin Coucke
Credit Portfolio Manager

Financial markets and the global economy are going through a period of significant transition and heightened risk. This is in large part due to the abhorrent attack on Ukraine and the ongoing war.

From the purely economic or investment standpoint, the long-term consequences and impact are still highly uncertain. Growth expectations are falling. Particularly so in Europe, with confidence surveys pointing to risks of recession.

Higher energy prices exacerbate inflation and could hurt consumer sentiment. This is particularly acute for Europe, which depends on Russia for energy, and has a more industrial and energy intensive economy. The US is energy self-sufficient and more services-based. These factors are being reflected in markets.

Bond markets have also been rocked by policy shifts from central banks, with multiple rate hikes expected in 2022, particularly from the Federal Reserve (Fed). We think tightening could be more moderate than expected, particularly in Europe, given risks to growth.

As our charts show, credit market valuations are reflecting a lot of negativity. Perhaps too much. Yields and spreads have risen markedly to appealing levels. Corporate fundamentals are starting from healthy levels and the default rate should be benign unless Europe has a deep recession, which we think relatively unlikely.

Credit yields attractive versus dividends

Yield income is a key attribute of corporate bonds, but for significant periods over recent years has been pretty scarce, with yields supressed by quantitative easing. Not so now. Yields look attractive outright and also next to equity dividends.

In the US, investment grade corporate bonds offer a 3.5% yield compared to a dividend yield of 1.4% on the S&P 500 stock index. That is the biggest yield “premium” since the second half of 2018.

In Europe, where companies pay higher dividends that exceed investment grade bond yields, the gap is at the lowest level since 2012. And it is worth remembering, companies are obliged to pay their bond yields, but have the discretion to cut dividends if needed. That is particularly relevant with growth slowing and companies facing higher input costs.

The extra income pick-up in the high yield market is the highest since 2013 (excluding the Covid-19 crisis in the second quarter of 2020).

Euro investment grade and high yield spreads are at the 80th and 75th percentiles respectively, relative to long-term historic levels.

US-IG-yield-versus-SandP500-dividends

Europe-credit-yields-attractive-versus-dividends

Value in European curve

The corporate bond spread curve for BBB-rated bonds has steepened and, while it has retraced, there could be further scope for reversion. The steeper curve reflects a wider difference in spread on shorter and longer-dated credits. It indicates better value in longer-dated bonds and good roll down prospects (when long-dated bonds offer approach maturity they offer added yield compared to short-dated bonds).

If the curve continues to revert back over time, longer-dated bonds will see positive capital returns. Longer-dated bonds have higher duration (sensitivity to yield or spread moves), so will garner higher returns as yields or spreads fall, as well as offering higher yields. 

BBB-curve-value-in-long-end

Investment grade fundamentals at high yield prices

Hybrids, such as perpetual bonds which have no fixed maturity, have seen their yields rise markedly amid the sell-off.

Since hybrid bonds are “subordinated” within the capital structure (this determined the hierarchy of claims to corporate cash flows), the bonds receive a lower credit rating than the issuing company’s more senior bonds.

So while the hybrid bonds will have a lower rating, and therefore higher yield and spread, the issuer fundamentals are the same.

The chart below is the yield on the Credit Suisse European Corporate Hybrid Index. Half of the index is BBB, but the 3.5% yield is closer to the ICE BofA Euro BB Index’s 3.7%.

Hybrid-bonds-IG-at-HY-valuations

High yield bonds reflecting a lot of bad news

The European high yield credit market is more sensitive to economic factors and has reacted strongly to recent events. The spread on European high yield is consistent with the European economy slowing to almost 0%, and a technical recession at least.

There are undoubtedly major challenges for the region, but there are also signs of still quite healthy economic activity, so this spread might well be too pessimistic.

High yield spreads are also indicating (going by historical levels) an excessive default rates. Many of the risks presently are at the macro level. Companies will feel pressure from rising input costs, but many have improved their balance sheets, refinancing debt at lower interest rates and holding more cash.

Market-implied-default-rate-excessive

HY-pricing-recession

Good medium-term return prospects  

We cannot time the turning point for spreads, but current valuations provide a good entry point and the return potential from credit looks healthy over the medium to long-term. In the past, credit spreads have not held at these levels for long.

Euro HY one and three-year excess returns from spread levels of 400-500 basis points (bps) have been good historically. We can see the improved return prospects from a year ago (the change indicated by the arrow) when spreads were about half what they are today.  

Positive-return-prospects-from-current-spreads

Margin of safety

The breakeven spread level indicates a margin of safety for corporate bonds. This is the level to which the spread would have to rise for returns to be negative over 12-months.

Credit-breakeven-level-offers-margin-of-safety

Security selection opportunities

The European credit market has become more dispersed. This means there is a greater range of valuations within the market and potentially more individual bonds will be mispriced. For active investors, this will throw up alpha opportunities. 

We are seeing a meaningful divide between cyclicals, where valuations do not reflect risks to growth, and more defensive, non-cyclical areas, where we have strong conviction. Sectors such as real estate and infrastructure operators, both with some in-built resilience to inflation seem attractive.

Given the pressure on consumers, retail and sectors dependent on discretionary spending look vulnerable. Likewise autos, with continued supply shortages and those sectors with high transport costs.  

Dispersion-euro-IG-opportunities

The chart below shows the spread of defensives (telecoms, utilities and consumer non-cyclical) versus cyclical sectors (basic industry, capital goods, consumer cyclical, energy, technology, transportation). We think there is scope for defensive sector spreads to perform well versus cyclicals. 

Defensives-cheaper-versus-cyclicals

Risk and reward balance looks favourable

We are by no means complacent about the global outlook, but a lot of risk and potentially adverse economic outcomes are reflected in credit markets. While there is a lot of risk in the world, and it is not easy to invest in these conditions, the balance between risk and potential returns now looks favourable overall.

There are opportunities across different parts of the market, with some cushion against further pressure, and fundamentals are healthy. It will be important to invest selectively and as the last chart indicates, judicious security selection should be rewarded.

Subscribe to our insights

Visit our preference centre, where you can choose which Schroders Insights you would like to receive.

Authors

Julien Houdain
Head of Global Unconstrained Fixed Income
Rajeev Shah
Global Credit Strategist
Martin Coucke
Credit Portfolio Manager

Topics

Follow us

Please remember that the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

This marketing material is for professional investors or advisers only. This site is not suitable for retail clients.

Issued by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU.

For illustrative purposes only and does not constitute a recommendation to invest in the above-mentioned security / sector / country.

Registered No: 1893220 England. Authorised and regulated by the Financial Conduct Authority.

For your security, communications may be recorded or monitored.

On 17 September 2018 our remaining dual priced funds converted to single pricing and a list of the funds affected can be found in our Changes to Funds. To view historic dual prices from the launch date to 14 September 2018 click on Historic prices.