Credit spreads narrowed quite sharply during 2019, boosting returns from corporate bonds. But with spreads now close to their lowest levels in two years, some investors are questioning whether the rally might be running out of steam. In this update, Craig Morabito, Co-Portfolio Manager of First Sentier Investors’ Global Credit strategies considers whether corporate bonds can make further progress over the next 12 months.

Investment grade spreads closed 2019 below 1% – can they go any lower? 

In the three years prior to the Global Financial Crisis, investment grade spreads averaged around 0.70%. And more recently, we saw spreads1 around 0.85% in early-2018.

So using historical levels for context, spreads certainly could go a bit lower, although we are not anticipating substantial moves. We already saw quite significant tightening in 2019; remember, investment grade spreads started the year above 1.50%, so to fall below 1.00% by year end was a sizeable move.

At this stage, a period of consolidation around current levels seems most likely as investors assess whether lower interest rates and economic stimulus packages in some regions are having their desired effect on activity levels.

We believe any widening in spreads driven by stretched valuations would likely see inflows into the asset class increase, as investors chase the higher yields on offer. That should limit any spread widening to around 20 basis points from current levels, in our view.

What’s that likely to mean for overall returns from credit in the year ahead?

In short, it suggests overall returns this year are unlikely to match those seen in 2019. Global corporate bonds returned around 5% more than comparable government bonds over the past 12 months. But without such a strong tailwind from narrowing spreads, returns could be a little more subdued this year. While the expected returns are consistent with current spread levels and limited expected movement, they should remain attractive relative to low – and, in some cases, falling – cash rates.
Investors with a healthy risk appetite may be able to boost expected returns by increasing exposure to high yield issuers where spreads – and, in turn, potential returns – are higher. That said, high yield issuers can be more risky than those in the investment grade sub-sector. Their earnings tend to be more volatile, requiring careful issuer selection and ongoing monitoring of business conditions and profitability.

Default rates have picked up a little in China – do you expect to see the same in other regions?

We’ve seen a few corporate bond issuers in China default on their interest repayments over the past few months. It’s important to note though that default rates in China were coming off a very low base, below developed markets. The increase has only lifted default rates into line with more developed markets, but the trajectory nonetheless requires attention. Like those in the high yield sector, credits in emerging markets typically carry higher risk due to the generally higher level of earnings volatility. This can affect companies’ ability to service their debt repayment obligations and, potentially, result in defaults.

It’s worth noting that global credit benchmarks have very low exposure to Chinese issuers. Even a material increase in default rates in China should not therefore have a meaningful influence on overall returns from a well-diversified global credit portfolio. First Sentier Investors’ range of global credit funds have similarly low exposure to China and did not experience any defaults during 2019.

Importantly, many of the earnings headwinds that have faced Chinese firms are not affecting those in other countries. Specifically, the trade conflict between China and the US has had a serious impact on some companies and industry sectors in China as lower export volumes have affected profitability.

What about the outlook for corporate earnings elsewhere?

Corporate earnings are holding up quite well in other regions, even as economic growth rates have tailed off. More than three quarters of US-listed companies announced positive earnings surprises for the September quarter of 2019, for example, underlining the resilience of corporate profitability. Again, investors will be keeping a close eye on companies’ earnings for the December quarter when they are announced over the next couple of months.

Furthermore, with refinancing costs coming down due to lower official interest rates, most companies should be able to service their debt repayments quite comfortably. We are not therefore anticipating a meaningful pickup in default rates worldwide, though there’s certainly no room for complacency. Our specialist credit analysts are trained to identify deteriorating issuers early, enabling them to be removed from portfolios before default risk starts to materially affect pricing.

Are there any countries or industry sectors that look particularly appealing currently?

We saw towards the end of 2019 that the European Central Bank’s asset purchase program can support credit valuations in that region. So far around a quarter of the asset purchases have been in corporate bonds, equating to an additional ~€5 billion per month of demand for European credit. That’s meaningful, although all regions are seeing strong demand and inflows reflecting investors’ hunt for yield as cash and term deposit rates remain very low globally.

Our credit funds are actively managed and country and regional allocations can vary over time, but we believe maintaining a very high level of diversification is the most sensible and prudent way of managing money in this asset class. Our flagship Wholesale Global Credit Income strategy, for example, is currently invested in around 400 companies. This should help minimise the performance impact of unexpected defaults. Generally, holdings are diversified across a wide range of geographic regions and industry sectors – that’s the way we’ve managed the strategy for nearly 20 years. It’s an investment philosophy that’s stood the test of time and we have no plans to change it in the year ahead.

[1] Spreads are the difference in yield between corporate bonds and comparable high quality government bonds. The spread reflects the higher risk profile of corporate debt compared to government debt.

The product disclosure statement (PDS) and Information Memorandum (IM) for the Colonial First State Wholesale Global Credit Income Fund, ARSN 093 045 713 (Fund) issued by Colonial First State Investments Limited (ABN 98 002 348 352, AFSL 232468) (CFSIL) should be considered before making an investment decision. The PDS or IM are available from First Sentier Investors on its website. Total returns shown for the Fund or any Portfolio have been calculated using exit prices after taking into account all ongoing fees and assuming reinvestment of distributions. Past performance is no indication of future performance. 


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