It feels strange to say it when the COVID-19 pandemic still rages globally and even those economies that are opening up retain many restrictions and support schemes, but credit fundamentals are evidently in exceptional health and continuing to improve.
Frustratingly for fixed income investors looking to buy bonds, the data seem to fully justify the high valuations we see in so many parts of our market at the moment; it really would not make sense to be able to buy bonds cheaply when conditions are so good. However, that should not deter us from buying what we think are good bonds – even if they don’t look ‘cheap’ – as the strength of fundamentals means the chances of picking winners is currently rather higher than average, especially in the lower rated sections of the credit markets.
Default rates have collapsed from where they were a year ago, having never reached levels anywhere near what was once feared at the onset of the pandemic. The trailing 12-month default rate for US high yield bonds fell to a new cycle low of just 3.07% last month (1.19% if you strip out energy companies) and for loans it was a staggeringly low 1.96% (1.68% ex-energy). In fact, the actual number of US HY defaults in the first five months of this year is the lowest it has been since 2011, and as the early COVID-19 triggered defaults roll off over the next months we would expect to see the 12-month rate drop sharply in the second half of the year, perhaps down to 2% or even lower.
Furthermore, ratings trends continue to support the declining default rate. According to ratings agency Moody’s, the ratio of upgrades to downgrades is ratcheting higher across the globe, even in the UK where there have been 2.4 upgrades for every downgrade in Q2 so far, a level only surpassed in one quarter in the last decade. In Europe the picture is similar but it is even stronger in the US, where there are now 3.8 upgrades per downgrade so far in Q2, making it the single best quarter in the last decade. It is a good time to be a credit analyst picking bonds.
With so much stimulus still to come and a roaring global economy expected in H2, these highly fertile conditions will likely persist and in our view opportunities for credit gains remain, despite current valuations. Consequently we think it’s sensible to stay exposed to these dynamics, while remaining fearful of the more uncertain inflation dynamics that could detract from returns should yield curves return to the sort of bear steepening trends we witnessed in Q1.