The first four months of 2019 saw corporate credit markets on pace for a solid rebound following a lackluster 2018 and tumultuous Q4. Then May happened. Equity markets tumbled. The yield curve inverted. Fed rate expectations switched from up to flat to possibly three cuts by year-end. And credit markets responded accordingly, with both the high yield bond and senior secured loan markets posting negative returns for the first time this year.
So, with all that behind us, where are credit markets heading? If the gains in June are any indication, credit markets may be poised to regain their footing and deliver positive returns over the back half of the year, albeit comprised primarily from yield. In our view, high yield bonds appear to be in a slightly better position compared to senior secured loans, although history shows that they trade with a relatively high level of correlation to each other. Any exogenous shock, either positive or negative, is likely to impact both markets in a similar fashion.
Key risks to this outlook include unexpected macro developments: an increase in global trade war tensions, indications that the U.S. economy is headed toward contraction instead of merely a slowdown, and changes in Fed rate expectations. We believe these potential risks would likely be more significant for equity markets, but nonetheless high yield bonds and senior secured loans would likely trade down in sympathy. Conversely, if economic conditions or the outlook for trade meaningfully improves, both high yield bonds and senior secured loans have room for further spread tightening, which could add capital appreciation on top of yield-based returns.
Optimism in credit despite global growth slowdown
While U.S. economic growth may be moderating from above-trend growth, as outlined in our midyear economic outlook, fundamentals within the credit space are generally positive. Recent sales and EBITDA trends have been positive, supporting corporate default rates well below historical averages. Spreads, which serve as a proxy for valuations in credit, are somewhat below 10-year averages but well above lows experienced in other low default rate environments.
In our view these factors, as a snapshot of fundamental credit market conditions today, contribute to our relatively benign outlook for the rest of the year. If anything, the generally solid state of these fundamental statistics could cause credit markets to outperform our expectations in the absence of bad news.
Market technicals bear watching
Similarly, market technicals, or supply/demand dynamics, across high yield and loans are balanced. The high yield market has had slightly higher new issuance compared to last year but has also brought in over $12B in retail fund flows. Loans, while suffering from nearly $20B in retail outflows year to date, have had an even larger reduction in net new issuance, more than balancing out the reduced demand from retail investors. We do think these statistics bear monitoring, however, as downside risks to our outlook would likely materialize first in supply/demand statistics before becoming evident in the fundamental statistics described above.
For instance, an acceleration in rate cuts (or rate cut expectations) by the Fed could spur additional outflows from retail loan investors, pressuring that market. If this change occurred because of a worsening outlook for the U.S. economy, CLO issuance, one of the largest sources of demand for loans, could fall, resulting in an even larger hit to the demand side of the equation for the loan market. While retail inflows for high yield bond funds could switch to outflows, we believe the technical picture for high yield is slightly more stable than that for loans, contributing to our slightly more positive view for that market. Taken together, both fundamentals (credit outlook) and technicals (market supply/demand) look, at a minimum, neutral, if not somewhat positive.
Main risk falls outside credit markets
So where does the risk lie in credit? We believe the predominant risk today falls outside of the credit markets – in where equities are going and how they respond to trade tensions, slowing growth and Fed interest rate policy. In our view, credit markets are in a position to follow equities, not lead them.
A slower but steady economic environment provides a supportive backdrop for high yield bonds and senior secured loans, but the market is not immune from a broad-based risk-off trade. If the fundamental economic outlook for the U.S. deteriorates significantly, our outlook for credit would change. In that type of environment, corporate earnings would be expected to fall, and default rates would likely rise above long-term averages from their current low levels. For now, we don’t see that happening over the second half of 2019, giving us comfort that supportive fundamentals for credit will continue.