Credit markets outlook

Last year was a great one for credit markets. Many consider ECB President Mario Draghi as the major catalyst driving the rally in this asset class. In July, Draghi commented that the ECB will do “whatever it takes” to preserve the euro, providing a much-needed boost of confidence. The presentation of the Outright Monetary Transaction plan in September, which involves the unlimited purchase of government bonds issued by struggling countries should they be placed under a bail-out programme, further drove the positive momentum.

Total returns from credit markets are expected to be lower in 2013 compared to 2012- Karl Falzon

Borrowing costs of countries such as Spain and Italy decreased considerably. Spain’s 10-year borrowing costs peaked at over 7.5 per cent, but the yield is now close to five per cent. Credit spreads tightened and yields fell considerably for both investment grade and high yield bonds. Credit default swap benchmark indices, which reflect demand for protection against defaults, dropped convincingly. The iTraxx Crossover index (which consists of credit default swaps on sub-investment grade European companies) decreased by more than 250bps during the year.

According to most benchmarks, investment grade bonds on average returned 10 per cent-13 per cent. High yield bonds on average posted returns in the high teens, around 18 per cent-20 per cent. The lower ratings levels of investment grade, such as A and BBB, tended to outperform the higher quality AAA and AA, reflecting investors’ chase of higher excess returns.

Total returns from credit markets are expected to be lower in 2013 compared to 2012. One basic reality is that yields are lower and spreads are tighter than at the start of last year. However, on balance the scenario for the asset class remains relatively constructive.

Credit spreads are not at all-time highs compared to historical averages and compared to expected default rates. Most forecasts expect high yield default rates to rise slightly from current levels of approximately two to three per cent; however, they are forecasted to remain below the average of recent decades which is closer to five per cent.

Many issuers took advantage of a very receptive market in 2012 to refinance and extend their debt maturities, reducing refinancing risks and strengthening credit profiles. Liquidity support from central banks is expected to persist, helping to keep risk premia at low levels. Inflation, which has a negative impact across fixed income assets, is likely to remain muted.

Slow growth is a negative prospect, however it will motivate companies to be cautious and control debt levels. Structural considerations relating to the demand and supply dynamics of credit markets are supportive for the asset class. With policymakers likely to keep rates low, credit markets will continue to attract investment flows seeking better yields compared to government bonds.

While the general backdrop for the asset class is quite supportive, looking forward it will become more important for investors to distinguish between good and bad credits. The latter part of last year was characterised by a wide-ranging rally. On the other hand, it is likely that 2013 will be more of a ‘stock-picking’ year.

In addition, investors should keep in mind that there are several major underlying risks. A number of these risks are linked to the possibility of a return of ‘event’ or systemic risk. Confidence in the effectiveness of the OMT, which is generally considered to have been the primary driver of the recent rally, could decrease. For example, investors could become increasingly anxious as to whether Spain will ask for a bailout and be placed under the ECB programme.

Political instability in some countries may deteriorate – raising doubts on further progress in resolution of the euro debt crisis. In the US, the lack of a more permanent resolution to the fiscal situation, particularly in relation to the raising of the debt ceiling, is likely to be a major issue. Also, economic growth may turn out to be considerably weaker than is currently being expected. In turn, this may result in weaker financials from bond issuers and higher default rates.

Inflation expectations could pick up, resulting in higher yields – this will have an adverse impact on credit markets. Finally, it is generally accepted that at some point the very accommodative stances adopted by policymakers will need to be reversed in some way. However, an erratic and strong movement upwards in rates and government bond yields (for example, if the market fears an end to the Fed’s asset purchases) will inevitably harm prospects also for credit.

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Curmi & Partners Ltd is a member of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

Karl Falzon is a credit analyst at Curmi and Partners Ltd.