Credit spreads have peaked suggesting a rally in corporate bond funds is on the cards, according to AXA IM’s Chris Iggo, who says he is even seeing value in some of the most bombed-out areas of the market given that the chances of a global recession are low. 
Credit spreads, or the difference between corporate and government bond yields, have been widening over the past year or so investors as called into the question the health of the financial system, therefore causing a ‘flight to safety’ into sovereign debt.
The ramifications of China’s slowing growth, big moves down in the prices of commodities such as oil (plus the financial contagion that could create) and fears that the US may be heading towards a recession have all caused this trend.
According to FE Analytics, the likes of the Barclays US Corporate Bond, IBOXX Sterling Corporate All Maturities and Barclays Global High Yield indices have all posted losses in local currency terms since March last year, while the likes of the FTSE Actuaries UK Conventional Gilts All Stocks index has been on the rise.
Performance of indices since March 2015
Source: FE Analytics
Iggo, who is chief investment officer for fixed income at AXA IM, has been relatively bearish on his own asset class for much of the past two years, but he thinks these falls are unjustified and, as such, believes investors should use this opportunity to up their exposure to corporate credit.
“Spreads have widened as oil prices have declined and both trends accelerated towards the end of 2015 and in the first weeks of 2016,” Iggo said.
“As evidence suggests that oil is now bottoming, it is also likely that credit spreads have peaked. While the outlook for global growth has softened over the last year the risks of an outright global recession remain low.”
He added: “As such we think this is an opportunity to add exposure to credit. Spreads are wide, interest rates are set to remain low and returns from credit markets are set to be better than in 2015.”
Iggo, as mentioned earlier, hasn’t always been so positive in his outlook for fixed income and has spoken about the severe valuation risk facing large parts of the bond market in the past.
While he thinks the recent flight to safety – which has seen both government bond yields to drop and the price of gold to rally – has made the likes of gilts, US treasuries and German bunds even more unappealing, he says corporate credit is extremely enticing.
Performance of indices in 2016
Source: FE Analytics
“At the beginning of 2015 we were very concerned about valuations in the fixed income markets. For government bonds, this concern remains in place as the entire German yield curve approaches negative territory,” he said.
“However, for credit – investment grade and high yield – there has been a significant valuation adjustment. Our view is that current credit risk premiums have moved to levels that suggest a much worse economic outcome than we expect.”
“We do expect high yield defaults to rise over the next year or so, but the bulk of the increase in defaults will come in oil and gas, and related sectors where cash flow has been severely impacted by the decline in oil prices.”
“Away from this sector, however, spreads are suggesting a default rate that looks too high. In the US, spreads across investment grade and high yield, have only been higher during three previous periods in the last 30 years – the 2000-2002 recession, the great financial crisis of 2008-2009 and the European debt crisis of 2011.”
“All three previous episodes proved to be good buying opportunities for credit.”
The area of the bond market that offers the best value, according to Iggo, is high yield due to his belief the oil price has now found a floor.
“A year ago the energy sector accounted for 14 per cent of the US high yield market. The destruction of capital value in that sector means it is less than 10 per cent of the total today, but it is still contributing around 170 basis points of the 785 basis points of the index spread and accounts for the bulk of the default risk and volatility of the index,” he said.
Performance of indices over 2yrs
Source: FE Analytics
“Excluding energy, the market offers a yield of well over 7 per cent. At the investment grade level, the current yield for the US market is 3.6 per cent, compared to a dividend yield on the S&P 500 of just 2.27 per cent. Of course there is some interest rate risk in the US bond market as the Federal Reserve [Fed] may still raise the Fed funds rate again this year.”
“However, if it does, the moves are likely to be limited and could be matched by declines in credit spreads.”
Given he is sanguine view on global markets, he says now offers and entry point into some of the most bombed-out areas of fixed income.
“On the commodities side, several issuers have taken steps to strengthen their capital structure in recent weeks and most have access to ample liquidity. In our view, this means that there are selective opportunities in the metals, mining and energy sectors and lower spreads there will benefit total returns across the investment grade markets,” he said.
