The COVID-19 pandemic ushered in a new era of unprecedented market moves and a seemingly endless amount of records. Within credit, markets witnessed some of the fastest and largest spread widenings, spread tightenings, inflows, outflows and countless other measures of market health. With the pandemic now (hopefully) firmly in the rearview mirror for domestic markets, a new environment has emerged for high yield bonds and senior secured loans. This environment is one where markets have been quite, well, predictable. And yet, at risk of overusing a word that was so in vogue nearly 18 months ago, the environment today is also unprecedented. Only five times in the past 34 years has the previous year-end yield to maturity predicted the following year’s return within 200 basis points.
- Credit markets have had a solid first half of 2021, with returns almost directly in line with those we forecast.
- The backdrop for credit heading into Q3 remains favorable given improving credit fundamentals, falling default rates and balanced supply/demand conditions.
- Spreads have nearly reached our year-end forecast. We anticipate returns being predominantly income based for the remainder of 2021.
It has been our experience that markets are normally not this boring. Inevitably something happens that shakes the foundation of stability that markets often crave. But roughly halfway through 2021, positive pandemic progress and a strong domestic economy have brought about a period of calm, stability and strength to credit markets. This poses a new and unique set of challenges for investors. One, tight spreads and low yields make finding returns more difficult, especially for passive or benchmark-constrained investors. Two, investors need to remain vigilant about where and how the next source of material credit volatility will emerge.
Market returns for the year provide one of our strongest examples of market predictability. When writing our Q1 and 2021 outlook, an environment when yields and spreads were marginally higher than where they are today, we noted that income returns for high yield bonds and loans would yield roughly 1.4% and 1.1% per quarter, respectively. When factoring in the potential for spread tightening, offset partially by rising U.S. Treasury rates, we estimated full-year 2021 returns at 6.8% and 6.7% for high yield and loans, respectively. After nearly six months, actual returns for high yield and loans are 3.11% and 3.15%, respectively. Accounting for another half-month of income between the time of writing and the end of June, the 6-month annualized returns for both markets are within 12 basis points of our estimate for the year. Again, we do not view this as a testament to our skills at forecasting, but rather an example of just how predictable the market has been. As we think about Q3, we see little to change our expectation that broad index returns will largely be driven by income, yielding a total return for high yield and loans of 1.4% and 1.0%, respectively. Capital appreciation, at least for passive, index-driven investors, is likely to remain severely limited.