In our midyear 2019 corporate credit outlook, we highlighted that credit market conditions were reasonably stable and that volatility, were it to occur, would likely emanate from the equity markets. Looking at markets today, not much has changed to move us from that position. That’s not to say that markets haven’t had some periods of excitement since the end of the second quarter. The month of August, in particular, which saw equities down at one point by more than 5% as the Treasury curve inverted and 10-year rates fell by more than 50 basis points, had the potential to portend a period of greater volatility. But returns midway through September have largely recouped August’s losses and have markets, at least for now, seemingly feeling better.
For the balance of 2019, we see little to change our broad outlook for high yield bonds and senior secured loans. We expect corporate credit markets to finish the year on a positive note, albeit with returns primarily generated from the embedded income component of both the bond and loan markets. As has been the case over the past quarter, we continue to think that high yield bonds are in a slightly better position than senior secured loans, but both markets are likely to experience a high degree of correlation to each other.
We believe key risks to this outlook, especially over the short term, will likely emanate from outside credit markets. Issues such as flare-ups in trade tensions, geopolitical developments in the Middle East, or signs of a worse-than-expected slowdown in U.S. growth could all result in a market-wide sell-off of risk assets, which we expect would include corporate credit. Conversely, optimism across markets, as seen in the first half of September, could cause total returns for credit to exceed income returns. Credit spreads, while tight, remain well off their post-financial crisis lows. Furthermore, lower-rated credits, which have underperformed higher-rated credits to date, could provide an additional source of return over the balance of the year if mid-September’s optimism continues.
Optimism remains despite signs of slowdown
Moderating growth in the U.S. has flowed through to revenue and cash flow statistics for high yield bond and senior secured loan issuers. Second quarter revenue and EBITDA growth statistics were similar to the first quarter and collectively represent the slowest start to a year since 2016. However, slow growth is not negative growth, and overall fundamentals for companies remain generally solid. Default rates remain low, and leverage and interest coverage statistics remain better than 10-year averages.
Credit spreads, which serve as a proxy for valuations, are currently tighter than 10-year averages but remain well above lows witnessed since the end of the financial crisis. Reasonably stable credit fundamentals, combined with what we believe are appropriately tight credit spreads, are key factors in our outlook for positive but primarily income-driven returns in Q4.
Market technicals remain favorable
Supply/demand dynamics for both high yield bonds and senior secured loans have improved further since the end of the second quarter. While the contributors to favorable dynamics are different between the two markets, the net result is the same; both markets have had more demand than supply.
The technicals data has been so strong year to date that it’s almost a given that full-year 2019 results will end the year favorably. However, there are scenarios that could cause Q4 to buck the trend of the previous nine months. For both markets, one of the wildcards is the pace of new issuance. Given the low yield environment combined with generally tighter spreads, will a growing number of borrowers look to issue debt as the year draws to a close? If a flood of new issuance coincides with reduced investor demand, it could be possible to see the strong technical environment of these markets reverse toward year-end.
Short-term risks remain outside of credit
In looking ahead to the last three months of 2019, we continue to believe that the primary risks to the credit market lie outside of the credit market. Stable credit fundamentals combined with strong market technicals will make it very difficult in our view for credit markets to meaningfully sell off independent of other markets.
A noticeable deterioration in trade negotiations, geopolitical risks or general economic conditions may very well cause credit markets to move lower, but we don’t see that happening in a vacuum. Any of these issues could result in a broad risk-off trade, which may include credit. In the absence of bad news, we continue to see favorable conditions for high yield bonds and senior secured loans to generate positive returns over the fourth quarter, composed primarily of the income returns these markets offer.