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In the first quarter, US Treasury yields rose, and the dollar strengthened, with a steady reduction in the number of 2024 rate cuts priced in. Although performance varied, most credit markets posted positive gains, with floating-rate products at the top of the performance table and spread tightening helping high-yield markets.
Jeff Boswell, Head of Alternative Credit, Ninety One: “At the start of the year markets were pricing in around 150 basis points of cuts by the US Federal Reserve over the course of 2024, but higher-than-expected inflation and surprisingly strong jobs data prompted a revision of this, and US Treasury 10-year yields rose from 3.88% to 4.20% over Q1. In Europe, 10-year yields also climbed across the continent, largely due to the currently high correlation between US and other bond markets.”
Despite this backdrop, credit markets performed well overall, with most delivering positive total returns. Unsurprisingly, the top-performing asset classes were floating-rate products, namely leveraged loans and structured credit. These benefited from the rise in risk-free rates, especially in the US. Other positive performers included both US and European high-yield bonds, as credit spreads tightened to help offset the negative impact of rising interest rates.
Boswell cautions: "In traditional markets, such as high-yield debt and US investment grade, credit spreads are nearing the tightest levels seen over previous cycles; we believe these offer limited potential for further price appreciation.”
US high-yield spreads – near historic tights
Boswell finds plenty of other – less-explored – areas for credit investors to explore. “Higher carry holdings – such as structured credit, loans, and selective parts of the short-duration high-yield and bank capital market – offer an attractive income profile and favourable downside characteristics. While less well-known, they are well worth considering at this point in the cycle.”
Even in these parts of the credit market, selectivity is key. Spreads in the Bank Capital, or AT1, market tightened further in Q1, continuing the remarkable recovery since the collapse of Credit Suisse last year. This resulted in a US dollar-hedged return of 3.8% in Q1 by the BofA Contingent Capital Index.
Boswell notes, “Given this persistent rally, we believe the attractiveness of valuations is less uniform and selectivity is increasingly important in the AT1 market. However, from a yield perspective, the AT1 sector still screens well, and bank fundamentals remain strong – as highlighted in the latest set of results – providing a constructive backdrop for AT1s. Interestingly around a quarter (26%) of AT1s are still pricing in some extension risk. Given that we have seen the majority of the banks call their AT1s at first call and expect this to continue in FY24, we think this extension risk is often mis-priced, especially for fundamentally sound issuers.” More details can be found in Picture this.
It was also a strong start to the year for EM corporate debt markets, with the JP Morgan Corporate EM Bond Index (CEMBI) returning +2.3% over the quarter. This positive performance in the face of higher developed-market sovereign yields was driven by the combination of carry and tightening of credit spreads, as investors’ appetite for risk improved.
To read the Credit Chronicle in full, click here.