22 July 2024. Credit markets had a positive second quarter from a total return perspective. In a similar theme to the first quarter, the top-performing areas of the credit market were assets with floating-rate coupons, such as leveraged loans and collateralised loan obligations (CLOs). Both benefited from the rise in risk-free rates early in the quarter, with high carry providing a boost over the rest of the period.
Darpan Harar, Portfolio Manager, Ninety One: “Another solid quarter for credit markets underscores how expensive parts of the more traditional markets are becoming. We continue to find more attractive opportunities in more specialist areas, with higher carry (higher income) holdings such as structured credit, loans, and selective parts of the short-duration high-yield and bank capital market, offering an attractive income profile and favourable downside characteristics.”
The second quarter marked a steady but uneventful period for investment-grade (IG) markets, with the Global IG index finishing the period with a 2bps wider spread, while still generating a small positive total return thanks to carry. All of the spread widening occurred in June following volatility driven by France-related headlines, marking IG’s worst monthly spread performance since March 2023. This was concentrated in the higher quality end of the market, leading to material spread compression between the BBB and single-A rating categories; the differential in spread between the two ratings categories is now at multi-year tights.
Turning to the high-yield market, although spreads in Europe widened towards the end of the quarter due to the French snap election-induced volatility and associated risks, the more important factor for both the US and European high-yield markets was that lofty valuations going into the quarter created a material headwind. In particular, spreads on BB rated bonds across both sides of the Atlantic touched multi-year tight levels in early May, with the option-adjusted spread on US BB rated bonds at one point falling to a level not seen since before the Global Financial Crisis. Figure 1 shows spreads for the US market.
Harar explains: “There is a clear case for investors to look beyond the high-yield market and explore further afield, where they can find higher quality assets that are paying similar if not higher credit spreads.”
Figure 1. US BB spreads, basis points
Source: BofA, 30 June 2024. Spreads are option-adjusted (OAS).
As Harar noted in June there are more compelling opportunities in more specialist parts of the credit market. For instance, tighter credit spreads and higher risk-free rates helped floating-rate collateralised loan obligations (CLOs) deliver another strong quarter of total returns. European and US BBB rated CLOs returned 3.2% and 2.9% respectively in Q2, according to JP Morgan Indices, which compares favourably with the European and US high-yield corporate bond market returns of 1.5% and 1.1% respectively. CLO market supply and demand dynamics remain robust, keeping prices well supported even through a pick-up in volatility for many other risk assets towards the end of the quarter (mainly prompted by French political developments). New-issue CLO supply is at record levels year to date in both the European and US markets, but an accelerating pace of CLO amortisation and liquidations has left net supply at a fraction of gross supply.
Harar concludes, “A further support for structured credit is growing demand from a range of investor types, including global banks, asset managers, and a small but fast-growing CLO ETF community. This has helped continue to drive spreads tighter across geographies, and across rating categories.”
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