As credit markets enter the fourth quarter, it feels a lot like we’ve been here before. While the news cycle revolves around the health crisis, possible Fed tapering and geopolitical tensions, the fundamental drivers of U.S. credit markets are well intact. The economy is firmly on positive footing, default rates are low and falling, and investors’ appetite for yield in a low-interest rate environment is unwavering. These conditions formed the basis for our views all year that credit markets would generate predominately income-based returns in 2021 with the potential for further spread tightening. We see little to change that view today.
Key takeaways
- Credit markets have had a solid first nine months of 2021, with returns almost directly in line with those we forecast.
- The backdrop for credit heading into Q4 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.
High yield bond and senior secured loan markets have certainly benefitted from the risk-on sentiment of equities. Market leadership has changed over the course of 2021, but the S&P 500 has posted seven straight months of positive returns since falling in January. Credit markets have followed suit, with high yield notching 11 straight months of positive returns and loans positive in 16 out of the past 17 months. With equity valuations near record highs and credit spreads coming close to or surpassing post-Global Financial Crisis (GFC) tights, we believe a change in broader risk sentiment is perhaps the primary risk to credit markets in the near-term. The fundamental and technical picture within credit is supportive of continued positive returns, but credit markets are ultimately not immune from shifting currents in other markets, particularly equities.
We are watching a handful of factors more closely and are introducing a new section to our outlook, What we’re watching. A supply/demand imbalance in credit markets certainly has the potential to create issues. Investor demand has supported a record level of issuance for both
bonds and loans, but a sudden shift in sentiment could cause this to change. At times, this can catch the market off guard as excess supply needs to be priced to clear the market. Taper talk from the Fed is also a concern, although any impact from rising rates may be short lived. Both high yield bonds and loans, for different reasons, have shown strong historical resistance to long-term duration risk. Lastly, valuations clearly reflect the strong underlying characteristics of credit markets. This does not mean that markets are due to crash, low spread environments can persist for years, but it does form the basis for our belief that returns will be largely based on income and not capital appreciation at the index level.
As the year draws to a close, credit markets remain on a solid foundation of supportive growth, improving earnings and balanced technicals. While we see opportunities for active managers to source incremental returns from corporate events, indexes may likely be constrained from a limited amount of further spread tightening. We look forward to watching the trends in Q4 as we look for clues about the path credit markets may take in 2022.
