Credit has been underperforming equities since the second half of last year. The trend, which accelerated in recent months, is likely to continue and warrants a rethink of portfolio positioning, considers Puneet Sharma, managing director and head of credit strategy in investment management at Zurich.
We believe credit markets are vulnerable for to a number of reasons. First and foremost, credit tends to lag behind equities during the late stage of the economic cycle. The current economic expansion in the US, for example, is the second longest on record. While we don’t expect an imminent end, the clock is ticking and risks are rising.
Second, while corporate earnings are likely to see solid growth in the coming quarters, this will likely benefit shareholders more than creditors. Indeed, debt levels are rising as fast as earnings, as corporate managements are keen to raise debt at cheap levels to fund investments, acquisitions and share buybacks. Mergers and acquisitions and leveraged buyouts are unlikely to slow, which is positive for equities but negative for credit.
Third, credit indices are dominated by large debt issuers, which often are the ones with the highest amount of leverage, although there can be some notable exceptions. These issuers tend to be the ones that have engaged in large scale M&As and other expensive investment activities. Needless to say, these can often turn out to be the credits under most pressure during cycle turns. In this sense, there is an adverse selection bias in credit markets, which is a structural disadvantage for credit investors at the current late stage of the cycle, in our view.
Last but not least, the median leverage of non-financial companies in the US and Europe is already higher than it was even at the depth of prior recessions. The vulnerability this creates to higher funding costs and earning shocks is obvious. The weaker high yield companies are already devoting substantial chunks of their earnings just to service interest costs. With such a backdrop, the normalisation of monetary policy, along with rising credit spreads, implies that funding costs are on the rise. This sets the stage for a wave of defaults and restructurings, once the cycle turns.
So two questions arise. Why are investors still buying credit? And are they being rewarded for it?
In our view, the answer to the first question is that investor demand is being driven by still abundant liquidity and the classic search for yield. That said, demand is now waning as seen by outflows in several credit sectors, as well as by spread widening and greater concessions being demanded in the primary market. Furthermore, central banks are reining back liquidity provision, with the US Federal Reserve shrinking its balance sheet and the European Central Bank stopping its asset purchase programme at the end of this year.
The second question is even more crucial. Are investors being paid for the risks? We don’t think so and we believe the spread widening that has already started has further to run. Risk reward is skewed to the downside, as spreads on a leverage adjusted basis are still near all-time tights. While equities are not cheap, risk reward is more symmetrical, favouring equities as an asset class, at least for now.
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