Credit markets took investors on a wild ride in 2020, but spreads ended the year nearly where they began. As it was the worldwide COVID-19 pandemic and related shutdowns that drove the markets down, we expect the improvements in Covid conditions and the loosening or removal of restrictions to lift the markets back up. One of our big themes for 2021 is “carry,” as we don’t see much potential for spread tightening in aggregate or capital appreciation. We remain wary of impairment in the high-yield market, but see that risk diminishing as fundamentals continue to improve.
Credit Market Review
- Credit markets experienced elevated volatility throughout 2020, largely due to impacts of COVID-19 and related shutdowns.
- Since the lows in 2020, however, credit markets have rallied sharply to end 2020 with spread levels nearly unchanged from where they were at the start of the year.
- Consumer fundamentals have improved since the initial Covid shock—personal savings are way up and indebtedness is down—which is unusual compared to impaired consumers we’d usually see when coming out of a recession.
- Corporate earnings were much better than initial expectations.
- Both consumers and the corporate sector have benefited from both timely and sizable fiscal and monetary policies in reaction to the pandemic.
Credit Market Outlook
- Performance in 2H20 and into 2021 indicate markets are pricing in a lot of optimism about near-term growth potential and the successful progress against Covid globally.
- If it was Covid that depressed markets and economic fundamentals last year, then a rebound can be expected as restrictions are relaxed or lifted and business resumes, especially in the services sector.
- We see positive momentum in all Covid metrics, with reported declines in daily tests, cases, hospitalizations and deaths.
- Vaccine efficacy and distribution efforts appear to be improving overall, and there is additional optimism for the new Johnson & Johnson single-dose vaccine to be approved soon.
- The consensus among market participants is looking for full reopenings by approximately July.
- Our US growth outlook for 2021 is about 7.5%, which would reflect a return to the 2.3% annual growth rate seen since 2015. For the services sector, we could see growth of about 10.5% for 2021 as reopenings take hold.
- BBBs have grown to reach 50% of the investment-grade market.
- Duration continues to extend, prices continue to increase and gross leverage continues to go higher.
- While spreads are currently low at below 100 bps, this is not unlike the periods of 1993-1998 and 2004- 2007, and we believe they can remain there given the healthy fundamental backdrop.
- Regarding technicals, we see a very positive tailwind given the ongoing increase of retail flows into the asset class.
- We saw a tremendous rebound in high-yield credit, especially toward the latter end of 2020.
- For 2021, while we don’t see great room for capital appreciation (spread tightening), we do see an attractive yield advantage versus other fixed-income sectors, but remain very selective.
- Improving default-rate trends look encouraging, and we believe the risk of impairment will continue to decline throughout 2021 as fundamentals improve.
- Historically, high-yield credit has done best when inflation is rising from below-average lows, which is likely the case this year.
Bank Loans and Collateralized Loan Obligations (CLOs)
- After two years of outflows, technical conditions in the bank loan market seem poised for improvement. Year-to-date flows have been very strong and seem to be gaining momentum with rates on the rise. We believe bank loans are a compelling “carry” story among fixed-income asset classes.
- Bank loans currently offer an attractive level of yield, without much, if any, duration risk.
- We see a technical tailwind ahead for bank loans and CLOs, especially in an environment of higher rates.
- In line with bank loans, CLOs and CLO tranche demand continues to grow.
- Commercial MBS (CMBS) valuations have yet to fully recover from the Covid-related damage, specifically with respect to office space, retail space and lodging.
- We think the market has priced in a worst-case scenario that may present value opportunities.
- CMBS spreads remain wide relative to high-yield.
Emerging Markets (EM)
- EM offers attractive outright and relative spread opportunities versus US credit.
- If rates continue to increase, we expect investment-grade credit to come under pressure given its lower coupon and longer duration profile, though we do not expect materially higher rates.
- In commodities, we are bullish on both oil and copper, selectively among issuers.
- After years of underperformance, we think the energy sector is poised for further gains.
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