Note

Quantifying COVID: Credit markets one year later

Credit markets have largely recovered from the pandemic. How could continued optimism impact investors?

Kara O’Halloran
March 17, 2021 | 10 minute read

Rich valuations, rising interest rates and inflation fears are dominating conversations across the credit-minded world. Spreads for investment grade bonds, high yield bonds and senior secured loans have all surpassed their pre-pandemic tights and are rapidly approaching post-Great Financial Crisis (GFC) lows. With income sparse across financial markets, even the recent record-low yields on many of these asset classes remain attractive on a relative basis. Still, many wonder if valuations are too rich to justify an investment. Now, one year later, we revisit our COVID credit update series to see where things stand — and where they may be heading.

Markets have, by and large, looked past the pandemic since roughly 10 AM on March 23, 2020, when the Federal Reserve announced monetary policies aimed at unleashing massive amounts of stimulus. That Fed action, combined with fiscal support from Congress, ushered in a relatively uninterrupted upward climb in markets for much of last year.

A year later, almost to the day, the end of the pandemic is (hopefully) no longer a matter of “if,” but “when.” As markets have climbed, a shift has begun to occur in the narrative with a renewed focus on themes that have been absent for some time: reflation, procyclicality and expansion. No matter what it is called, things have felt different in markets for the past few months.

In credit, we’ve seen this play out in a few ways. Spreads have retraced to the levels we saw in late February 2020, yields on both investment grade and high yield corporate bonds have touched record lows, and market leadership has rotated to lower-rated assets and those in more cyclically sensitive sectors.

The outlook across risk assets remains broadly constructive. Markets look to have entered a new economic cycle where stimulus is abundant, the Fed is omnipresent, and vaccine distribution is both a metaphorical and literal shot in the arm needed to sustain upward momentum. This rapid spread retracement has left credit markets starting this new cycle largely where they left the old one — with rich valuations across the credit spectrum. In this note, we assess what this means for credit investors today, one year after the COVID-crisis market bottom.

Key takeaways

  • Credit markets have largely recovered from the pandemic, and optimism around the continued recovery abounds.
  • Although spreads are tight across credit markets, quality among them has largely diverged.
  • By ratings mix, the high yield bond market has increased in quality in recent years, while both the investment grade bond and senior secured loan markets have deteriorated.
  • We continue to see high yield bonds as attractive given the relatively higher-quality market, above average income and limited duration risk.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

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Kara O’Halloran, CFA

Director, Investment Research

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