Credit Chronicle: A solid quarter in credit markets

A decisive positive shift in market sentiment made for a solid quarter for credit markets.

15 Jan 2024

15 January 2024, A sharp decline (rally) took place in US Treasury yields across the yield curve, with the 10-year note ending the year at 3.88% (having begun the year at 3.87% and the quarter at 4.57%). For credit markets, the fall in risk-free rates and improved risk appetite led to a strong quarter for total returns across the board, according to Jeff Boswell, Head of Alternative Credit, Ninety One.

“The last quarter of the year was a strong one for credit markets, thanks to a decisive positive shift in market sentiment. At the start of the period, sentiment was weak as market participants continued to anticipate a ‘higher for longer’ interest-rate outlook in the US. But November brought a positive shift in both investor sentiment and market performance, on reignited hopes that the US Federal Reserve’s (Fed’s) rate-hiking cycle had come to an end and that the Fed could begin cutting rates in 2024. Coupled with encouraging economic data, this provided a significant boost to global credit markets and a strong end to the year,” Boswell stated.

Global high-yield markets posted their best quarter since Q2 2020, with the rally in spreads and yields driven by renewed hopes of a soft landing for major economies. US and European high-yield debt markets returned 7.7% and 5.6% respectively, to end the year up 13.5% and 12.8%. Global investment grade markets also finished the year on a very strong note, returning 7.1% in Q4; although credit spreads tightened by 10bps in the quarter to reach multi-year lows, the move in risk-free rates was the primary driver here. While floating-rate assets, such as collateralised loan obligations (CLOs), lagged fixed-coupon areas of the market, spread tightening across rating categories allowed them to also participate in the rally.”

In the high-yield debt market, while BB rated debt outperformed (+7.9%) given its higher rates sensitivity, there was also a meaningful amount of spread compression in lower-quality segments, especially from the early November spread wides.

As a result, most high-yield market segments ended the year trading well inside the 10-year averages, with US BBs and Bs at their 18th and 27th percentile (100th being the widest). Technicals played an important role in all of this, with 2023 US high-yield issuance at a mere US$196 billion – while 69% higher than 2022, still scant relative to the pandemic era when issuance was above US$400 billion for consecutive years.

Boswell stated: "Limited issuance, coupled with still significant upgrades into investment grade has left the US high yield market still 26% smaller than at its 2021 peak – a very favourable technical setup indeed.”

US BB versus US BBB spreads are near historic tights

Source: ICE BAML, Bloomberg, 31 Dec 2023. US BB = BofA US BB (HUC1), US BBB = BofA US BBB (CY40).

In contrast, in the investment-grade market investors face a conundrum - while current IG spread valuations look increasingly expensive relative to history, headline IG yields still look relatively elevated through the same lens (even after a decline of more than 100bps from recent highs). The question is whether the lack of spread premium starts to make the asset class look less attractive to yield-focused buyers.

For the most interesting opportunities, it is worth looking off the beaten track. For instance, historically, leveraged loan performance after a pause in Fed hiking has been quite strong (albeit the sample is admittedly small) with average subsequent 12-month returns of 7.5% for US loans and skewed to higher quality (BB +7.7%; B +6.9%; CCC -4.6%). This is perhaps unsurprising given the higher likelihood of the lagged impact of already implemented hikes on the lowest-quality issuers. It remains to be seen if that is the outcome in 2024 as investors wrestle between the benefit of all-time high yields for the asset class and the fundamental challenge those high yields present for many issuers.

Boswell warns: “Although there are areas in both loan and CLO markets where the risk-reward trade-off remains attractive, assessing tail risk is crucial, particularly as valuations appear to be pricing in increasingly optimistic macroeconomic and credit outcomes.”

A notable turnaround came in the bank capital market, helping to end a difficult year on a positive note. Bank capital, or contingent convertibles, posted a strong Q4 with a total return of +8.6%, continuing the trend from Q3 and comfortably outperforming comparable asset classes such as high-yield corporate debt. An important catalyst for the bank capital market came in November as Swiss bank UBS issued a dual tranche AT1 deal (US$3.5 billion in total) into a book of US$36 billion.

Boswell explains: “The importance of this deal cannot be overstated given it was the first benchmark issue from a Swiss bank following the Credit Suisse AT1 write-downs earlier in 2023, and the strong order book (which, to contextualise, represents around 15% of the CoCo index) highlighted the strong investor demand for the asset class.”

“In total, approximately US$8 billion of AT1s were issued in Q4, which saw other national champion banks as well as some medium-sized banks come to market. The continuation of most issuers calling their bonds in 2023 as spreads continued to rally, improving the call dynamics, and we expect this to continue in 2024.”

To read the Credit Chronicle in full, click here.

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