With some commentators talking about the third credit bubble since the 1990s, CQS’s Craig Scordellis explains why he believes there are pot holes but not black holes in current credit markets.
There comes a time in every market cycle when exuberance gives way to caution and deleveraging, and in recent months bond markets have come under scrutiny amid concerns of a "credit bubble".
An asset bubble happens when markets value an asset at a price that significantly exceeds its intrinsic value.
So, where are we currently sitting in the credit cycle and are credit bubble concerns justified?
Supportive fundamental and strong corporate performance
In our view, to generically talk of a credit bubble in the current market is inaccurate. While credit spreads are at the tighter end of historical ranges, there is still sufficient dispersion and company-specific opportunity. When we think about a credit cycle, one of the first things we are focused on is the corporate default cycle. In many asset classes within credit, investors are still being well compensated for the probability of default.
From a macroeconomic perspective, underlying economies, especially in the US, Europe and many parts of Asia, are supportive of credit markets, while quantitative easing has helped to keep default rates relatively benign and maturities extended.
Looking more closely at corporates’ financials, the ability of businesses to service their debt requirements continue to improve in US and EU high yield and corporate performance has been good from a debt investor perspective. In addition, our market analysis shows that most sub-investment grade credit indicators are positive and substantially stronger than prior to the most recent 2008-09 default cycle.
When thinking about the credit cycle, it is important to note that there are a variety of sectors and credit sub-classes that have differing cycles. Defaults can be specific to individual sectors, such as the technology and telecommunications sectors in 2000-01, and oil and gas in 2015-16.
Currently, we are aware of the potential for underperformance within certain sectors of credit markets, such as property and US retail. However, in the short- to medium-term, the good news for credit investors is that corporate default rates should remain relatively low.
Pockets of opportunity
In the last seven years, the size of credit markets and the number and breadth of credit securities traded has grown significantly. This has been driven by new investor demand as institutional investors have refocused on corporate credit and central banks have lowered the cost of capital through quantitative easing.
A larger credit market means more choice for investors and can create greater dispersion between different types of credit, facilitating more opportunities for experienced credit managers to undertake fundamental research.
In our view, credit markets are presenting some excellent investment opportunities at present, particularly in complex asset classes and those that offer additional returns to compensate for illiquidity. Asset classes with these characteristics include loans and parts of the asset-backed securities market, which are also floating rate and therefore are less likely to be impacted by rising interest rates.
In Europe and the US, there have been rolling pockets of stress, distress and dislocation in a number of sectors including retail, energy and financials – what we refer to as ‘idiosyncratic opportunity’. However, these asset class opportunities still require substantial fundamental credit analysis to select the best investment opportunities.
Investment market outlook
Looking forward, we believe a ‘lower for longer’ interest rate environment should be attractive for credit. While the current environment lends itself to lower growth trends, high growth is not essential for good returns within credit.
The influence of geopolitical risk is highly prevalent in global financial markets and credit markets are certainly no exception. We continue to monitor key geopolitical risks, including tensions on the Korean peninsula, the fall-out from Brexit, hurdles faced by US President Donald Trump and unrest in the Middle East.
Generally speaking, equity markets are more likely to experience higher volatility than broad credit markets, which benefit from income to offset volatility. While we need to approach markets cautiously owing to the potential influence of central banks as their monetary policies begin to normalise and interest rates rise, we believe that for many investors, alternative credit in a multi-asset format is an attractive solution to de-risking from equities and maintaining reasonable expected returns.
Craig Scordellis is the head of long only multi-asset credit at CQS.
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