Outlook 2019: Global credit
Valuations have become more attractive and fundamentals are reasonably positive. But a period of transition looms, with central bank support being withdrawn and government bonds now offering a more compelling alternative than they have in many years.
- With the removal of extraordinary central bank support measures, 2019 looks set to be a transitional year, not just for corporate bonds
- Credit fundamentals are healthy, but the outlook for demand and sentiment is uncertain with rates rising and the credit cycle maturing
- Tougher markets in 2018 have resulted in attractive corporate bond valuations, while defaults and new supply are expected to remain low
The past year has been challenging for most areas of the credit markets not least due to a transition from quantitative easing to quantitative tightening. This, among other things, has the potential to weigh on markets again in 2019.
The outlook for credit is finely balanced. Fundamentals are healthy across investment grade (IG) and high yield (HY) issuers while the macro backdrop in the US remains strong. This is offset by declining demand and sentiment as rates rise and the end of the credit cycle approaches.
Solid credit metrics and low default rates persist
Within investment grade, revenue growth remains positive, but recent results indicate that the pace of growth has moderated as the benefits of US tax reform fade. However, earnings growth continues to outpace debt growth which has led to an organic improvement in leverage metrics (see chart below). This is expected to continue for the next few quarters. Overall, IG corporates are in good shape fundamentally but starting to show signs of late-cycle behavior.
Year-over-year investment grade EBITDA, sales & total debt growth
Source: Morgan Stanley
High yield (HY) companies have posted solid earnings growth, on aggregate, throughout the year with balance sheets remaining realtively healthy. Due to the strong economic backdrop, particularly in the US, and healthy earnings, the Moody’s trailing 12-month global default rate remains close to historical lows and is expected to fall from 2.6% at the end of October 2018 to 2% in late 2019. The distressed ratio, an indicator of defaults six to nine months in advance, also remains subdued, while ratings trends are favourable.
Two areas of concern include the growth in BBB-rated IG as well as the tremendous growth of the leveraged loan market within sub-investment grade. BBB-rated companies now constitute half of the IG market (Bloomberg Barclays US Corporate Index), up from 35% a decade ago*, although a significant percentage of the growth has come from more defensive companies migrating from A-rated down to BBB following a merger and acquisition (M&A) event. The leveraged loans market could be vulnerable to dislocations should economic conditions deteriorate, potentially impacting the broader corporate bond market.
Supply to remain supportive but demand uncertain
New investment grade issuance is expected to decline between 5-10% in 2019 after falling by nearly 10% in 2018. About 20% of issuance this past year has been to finance M&A transactions. This is expected to fall next year as higher all-in yields, increased equity volatility and recent tax changes are likely to deter such activity.
In HY, negative net supply (see chart below) has provided a key technical support, as in 2017. Gross new issuance is down nearly 40% year-over-year as opportunistic refinancing is less attractive, rates have risen, and with the shift in issuance from bonds to loans. The HY bond supply deficit is the highest in over a decade, according to JP Morgan, and we expect this key technical support to continue.
US high yield net supply in US dollars (millions)
From a demand perspective, corporate bond mutual fund flows turned negative towards the end of 2018 after three solid years of inflows. Investors have been concerned by rising rates, trade-related fears and higher hedging costs. The withdrawal of accommodative policy by central banks will likely result in lower demand for corporate bonds.
As rates increase, those investors who moved down the credit quality spectrum to achieve return goals amid the low rate environment will no longer need to do so. One potential mitigant is demand for long-dated corporate bonds from US pension plans, which are on average 90% funded, and may look to de-risk by rotating from equities to bonds.
Unlike IG, the HY market was never a big beneficiary of foreign demand, but still managed to perform well in 2018. This occurred despite steady outflows through 2018, primarily due to a dearth of new supply.
The recent market weakness has made valuations more attractive and we see scope for investors to re-evaluate HY and possibly add to allocations given strong fundamentals, attractive yields and the positive supply dynamic.
Credit valuations attractive once more
With sentiment shifting amid increased equity volatility, declining oil prices and geopolitical concerns, credit valuations have become more attractive. Global investment grade yields are at levels not seen since mid-2012 while spreads are 50 basis points (bps) higher than the post-2008 lows recorded earlier this year. Given solid fundamentals and expected decreasing supply, we see this as an attractive buying opportunity.
For HY, valuations posed a challenge for much of the year. Spreads remained in a tight range, primarily due to the lack of new issuance, even as other risk assets hit turbulence. HY also benefited from its shorter duration, so was less affected by rising rates, as well as less exposure to trade concerns given the domestic nature of the majority of HY companies.
As in the IG market, HY spreads began to widen in the fourth quarter, due to weakness in oil prices and equity volatility, and are now well above the cycle tights seen earlier in the year. Current pricing looks attractive enough to draw investors back, especially given the benign backdrop for defaults.
2019 a year of transition for credit
After nearly a decade of expansion, September marked the first time since the crisis that central bank balance sheets contracted. We see this continuing with the European Central Bank (ECB) expected to conclude its corporate bond-buying programme at the end of 2018 and other central banks beginning to cut back asset purchases. We will monitor the impact on corporate bonds closely.
Credit fundamentals are in good shape for the new year while the likely decline in supply is a positive somewhat offset by uncertainty around demand. We think attractive valuations and a strong macro backdrop, particularly in the US, could lure investors into corporate bonds across the credit spectrum.
Overall, we see idiosyncratic risk persisting and becoming more of a theme in 2019, bringing increased opportunity to generate returns through issuer and industry selection. That said, despite the broad improvement in valuation, it will be important to remain disciplined and selective to ensure adequate compensation for risk.
This article is part of our Outlook 2019 series, please check back for more over the coming days and weeks. The previous 14 in the series can be found by visiting our outlooks hub and / or by clicking the links below:
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