As we write this outlook—in late March 2021, almost one year to the day since markets bottomed amid the COVID-19 crisis—we can’t help but reflect on how the past year has unfolded. In many ways the world today looks almost unrecognizable. But markets, ever forward looking, have broadly looked past the pandemic since late March 2020. We are now, to a degree, comfortable doing the same in our outlook for credit.
One quarter in, 2021 is thus far playing out largely as we expected in our Q1 and 2021 outlook. There is a sense of (relative) normalcy, especially when compared with our mindset writing this outlook a year ago. In our view, the backdrop for credit markets remains supportive and is relatively unchanged versus the start of the year, with a few exceptions. Mass vaccine distribution is well underway, and timelines to reach herd immunity have been accelerated in recent weeks. Consensus forecasts for economic growth are robust, and the passage of the $1.9 trillion stimulus package should provide a further tailwind to the recovery, as evidenced by recent GDP estimates of 5.5%–7.0% growth this year, up from 3.9% three months ago.
This economic strength and continual progress toward a full reopening, plus a strong market backdrop, has impacted credit in expected ways. Markets inched higher for much of Q1 while default rates seem to have peaked well below levels predicted at the onset of the pandemic. Most forecasts now call for default rates to continue to trend down, with some calling for just 2% by year-end, below long-term averages. Perhaps the most surprising thing witnessed this quarter was the strength in the U.S. Treasury market, particularly in the 5-year note, which generally has the greatest impact on high yield bonds. Entering 2021, many, including us, anticipated that long-term interest rates would rise given the general economic optimism and massive amounts of stimulus. We expected this strength in Treasuries to contribute to the moderate spread tightening that we had forecast for high yield bonds. What we did not necessarily anticipate was the magnitude and speed of the sharp rate spikes, which began in mid‑February. These spikes caused ripple effects across markets; core fixed income has continued to struggle and equity markets, especially large-cap growth stocks, declined. This caused periods of broader risk-off sentiment, which spilled into credit as high yield bonds also declined, albeit far less than equities.
Given the economic backdrop, we would not be surprised to see long-term rates continue to rise. In our view, assessing the impact of these interest rate moves is one of the most pressing issues facing credit investors today. High yield bonds can certainly have exposure to duration in the short term as markets digest rates moving higher, as we witnessed for much of late February and early March. Over the long term, however, our research shows that rising rates driven by an improving economy are not a long-term negative for credit. In fact, high yield spreads have historically tightened during these environments, as economic strength generally leads to improved corporate fundamentals and declining default rates. The impact on senior secured loans is much more straightforward as their floating rate coupons leave them less exposed to changes in interest rates and the positive fundamental tailwinds benefit issuers.
With the broad backdrop outlined, we now turn our focus more specifically to the coming quarter. As we’ve discussed, default rates are trending down, and the technical picture has shifted from one of extreme excess supply in 2020 to a relatively more balanced picture. Loans have been aided by the influx of investor inflows, as we predicted in early December last year. Even though short-term rates, which, as the reference rate for floating rate products, are more relevant for loans, have not moved, investors have still shown a definitive preference for the asset class. The CLO primary market has been reignited, with strong new issuance and heightened levels of refinancings and resets, all of which have added to this demand for loans.
High yield bonds have seen outflows from retail investors in recent weeks, but the slowdown in levels of fallen angels plus a coincident increase in rising stars have leveled out supply in this market as well. Fundamentals are improving; revenue and EBITDA growth continue to bounce back from the steep contractions we saw during the height of the lockdowns in Q2 2020, and forecasts call for full-year earnings to surpass those we saw pre-pandemic. Last year’s strong markets led to record debt issuance, meaning many companies have refinanced at favorable interest rates and extended maturities, positioning their capital structures well for 2021.
Given this broad-based strength, spreads are tight. We expect returns to broadly be income driven this quarter, which would equate to roughly 1.3% return for high yield bonds and 1.1% for senior secured loans. We maintain our conviction that spreads in both markets will test or surpass post-Global Financial Crisis (GFC) tights at some point in 2021, but the difficulty in forecasting when the ultimate spread tightening will occur leaves us most comfortable assuming returns will be broadly from income in Q2. The technical tailwinds for the loan market outlined above could lead to modestly more spread tightening for loans in the coming quarter, especially if rates continue to rise, which may lead to a similar return in each market despite the relatively higher current income of bonds. The vastly improved quality of the high yield market over the past decade, which we outlined in a recent piece, lends credence to our view that while spreads are tight, they could go tighter over the remainder of the year. However, with much of the broad beta rally likely behind us, we think active managers are best poised to unlock the most opportunities in credit right now.
While we view markets as positioned for strength, near-term risks to this view include further swift interest rate increases and signs of rising inflation that could cause a risk-off environment. We believe that rate-induced weakness would cause only temporary weakness for high yield bonds and loans, but nonetheless we are watching them closely. And while the end of the pandemic is hopefully in sight, the virus is lingering. Any signs of surging infections could prompt further lockdowns and rattle markets once again. Given the potential for either of these events to cause volatility against a backdrop that we believe is otherwise favorable, we think potential remains for investors with deep bottoms-up credit expertise.
Key takeaways
- Credit markets have continued their upward climb in Q1, with loans outperforming bonds given their relatively favorable technical backdrop.
- Markets generally appear to be back at pre-pandemic levels, but policy support and an emergence from the pandemic exist as tailwinds that were not present for much of last year.
- We maintain a favorable outlook, but baseline returns will be primarily carry-driven. With spreads currently at relatively tight levels, we believe active, flexible managers with the ability capitalize on intra-asset class arbitrage and any lingering dispersion among ratings and industries will be best positioned to generate excess returns in the coming quarter.
