A big week for rates with the BoE centre stage
With the Fed, the Reserve Bank of Australia and the Bank of England all opining on monetary policy this week, government bond markets have been at the epicentre of every investor's consideration. Accordingly, rates volatility has spilled into credit markets. So, with this heightened volatility as a backdrop, we thought it appropriate to reflect once again on current credit fundamentals, which, despite the rise in volatility, are actually incredibly supportive.
Through October, US high yield credit saw its tenth consecutive month of positive rating migrations, with both the number and volume of upgrades outpacing downgrades. Year to date, ratings agencies have upgraded 359 US high yield issuers, totalling $546bn, while downgrading 158, with a value of just $175bn. As a result, the ratio of upgrades relative to downgrade by volume is at a record-high of 2.56:1.
Moreover, there are no warning lights flashing for the distressed universe either. Stresses observed in this sector can be considered a precursor to increasing default activity. The sector is composed of bonds trading at sub- $70 and represents just $12.8bn in size or a mere 0.8% of the US high yield universe. For reference, the distressed universe of bonds stood at $75bn in Feb-20 (pre-pandemic) but has hovered at historically low levels last seen in 2007.
Looking at current defaults, the US high yield default rate has declined 632bp year-to-date, to just 0.44% on a rolling 12-month basis (or 0.23% Ex Energy), the lowest rate since December 2007. Furthermore, if you apply this year's average monthly default rate to the final two months of the year, the US high yield bond default rate for the entirety of 2021 would total just ~0.35% (due to defaults from 2020 exiting the 12-month rolling calculation).
While these low default rates are highly supportive in the short term, participants expect them to persist for the medium term, given a positive backdrop. Indeed, improving credit fundamentals, a meagre distressed cohort and wide-open access to capital markets led JP Morgan to revise its 2022 high yield bond default rate forecasts from 1.25% to 0.75%. In addition, JP Morgan has also forecasted a high yield bond default rate of just 1.25% for 2023.
Moreover, in the context of a long-term average default rate of 3.6% for high yield bonds, current defaults are running at very low levels. Therefore, with forecasts remaining low and credit fundamentals as supportive as they are, the outlook for the asset class continues to look compelling.
When we experienced similar rate volatility in Q1 of this year, credit spreads eventually tightened. This time, rates markets have acted as the source of risk, leading to widening credit spreads, particularly in Europe and the UK. However, unlike equity markets, credit spreads have not yet bounced back. Therefore, given the fundamental backdrop of both US and European high yield markets, we think the case for credit remains solid and this recent bout of volatility might represent an attractive entry point or opportunity to top-up favoured positions.