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Credit at a Crossroads

Market volatility at the end of 2018 understandably tipped off an array of analysis—from whether it marked a larger turn in the economic cycle and the market to whether it increased the attractiveness of some investing opportunities. And if the latter, where those opportunities might lie. We believe that despite some signs of economic softening, the broader economic and market cycle are likely not over. Further, volatility has indeed introduced new compelling investing opportunities—though likely not where many would first look.

Sentiment Overshadows Fundamentals

For the first three quarters of 2018, corporate credit markets managed to defy gravity. A near-perfect environment, largely ring-fenced from macro noise, encouraged investors to dismiss downside risk in search of incremental yield—pushing credit-risk premiums to new post-crisis lows in October. But this trend changed quickly in Q4, as the perfect storm of softening economic data, decelerating earnings and worsening trade tensions pushed the sentiment pendulum sharply toward risk-off. Spooked investors withdrew a record amount of cash from below-investment grade funds, resulting in a selloff that wiped out all the year’s gains and led to the largest three-month widening for credit spreads since the European sovereign debt crisis in 2011. 

Q4’s uptick in volatility raises natural questions about whether it signals an end of the credit cycle and the beginning of the economy’s roll from expansion to recession. While the economy does appear to be softening as US fiscal stimulus fades, we see little to suggest a more material slowdown is on the horizon. In our view, the value proposition of high yield credit remains intact as the fundamental backdrop looks largely similar to years past. Aside from a handful of industries, corporate fundamentals remain stable and are buoyed by 2018’s strong earnings growth. Leverage levels remain in check or are improving, while interest coverage ratios are supported by relatively inexpensive debt. Combined, these factors should keep default rates anchored at currently low levels. Perhaps more significant, the Fed’s recent indication it would shift toward a more patient approach to further rate hikes suggests monetary conditions are likely to remain reasonably accommodative in the near term. Putting this together, 2018’s underperformance sets up well for credit investors in 2019. The end-of-cycle concerns implied by the downward volatility to end 2018 have been offset by meaningful spread widening, making the risk/reward profile of high yield credit the most attractive it’s been in some time.

Dissecting Dispersion

While the sharp repricing to end 2018 was dramatic, beneath the surface the dislocation was even more severe. Valuations across credit markets improved dramatically as single-security dispersion moved to multi-year highs. Increased dispersion suggests the emergence of a healthy skepticism between credits relative to last year (Exhibit 1). With a wider set of valuations, alpha opportunities are more abundant as market inefficiencies become more pronounced. For active managers today, diversity in bond pricing reflects a more robust opportunity for credit-selection. In our view, fundamentals ultimately drive returns and the ability to assess credit risk independent of ratings agencies can create meaningful opportunities for outperformance when opinions of market direction diverge. Skillful credit analysis can uncover total return opportunities in credits whose prices are disconnected from fundamentals, or in those that have been harshly impacted by negative market conditions.

Today’s opportunity set stands in stark contrast to the last twelve months when credit market valuations were priced for a near “goldilocks” market environment. With little differentiation between bonds across sectors, industries and credit quality, the limited dispersion created an increasingly asymmetric market with limited upside potential and proportionately less room for error.

Exhibit 1: Spread Dispersion for US High Yield Bonds

Source: ICE BofAML, Artisan Partners. Yield spreads based on December 31, 2018 option-adjusted spreads for constituents in the ICE BofAML US High Yield Index.

 

Looking at opportunities in the current environment, dispersion at the industry level is greater for the most economically-exposed segments of the market (Exhibit 2). Throughout Q4, concerns of declining growth and end-of-cycle risks led investors to shed credits even remotely exposed to economic headwinds, leaving more idiosyncratic opportunities as a result. For example, the swift decline in oil prices (reminiscent of the 2015/2016 downturn) led to indiscriminate selling across the energy complex. Even the highest credit-quality constituents with economically desirable acreage and strong balance sheets, were dragged down by the sector’s, creating attractive idiosyncratic investment opportunities for discerning investors. Elsewhere, the significant growth of the BBB portion of the investment-grade market has raised concerns about fallen angels. Valuations for some of the most leveraged BBB borrowers have reached high yield levels, but despite ratings pressure, most of these issuers have a multitude of options to mitigate the risk of being downgraded. In our opinion, the doomsday scenarios that have grabbed headlines create a number opportunities for meaningful outperformance.

Exhibit 2: Mapping Sectors by Dispersion and Spreads

Source: ICE BofAML, Artisan Partners. Yield spreads based on December 31, 2018 option-adjusted spreads for sector constituents in the ICE BofAML US High Yield Index. Dispersion calculated as the standard deviation of the OAS of all sector constituents. Sectors with markets values less than 1% of the ICE BofAML US High Yield Index are excluded.

 

Summary

Prolonged periods of relative calm can lead to short-lived bouts of volatility, and in our view, the turn in sentiment to end 2018 was an overreaction after what had been several quarters of complacency. While we acknowledge the move in spreads looks threatening—especially in relation to the stability seen over the last 12 months—the current cycle has included ample periods where spreads have increased by as much or more over a similarly small window. None of these periods marked the end of the economic cycle and, in our view, this time need be no different. Going forward, we expect volatility will be an ongoing theme as investors contend with many of the same issues that weighed on markets in late 2018.