Where does our head of global credit see opportunity next year? Gary Herbert joins Brian Giuliano to discuss global credit markets, opportunities and risks for 2018.
Q: Starting the year off, would you venture a one-sentence summary of the state of credit markets?
A: The macro backdrop remains solid. Steady, reasonably strong, broad-based global growth, with limited signs of inflationary pressures with respect to interest rates and credits in the US. And in terms of the U.S. economy, there are ac number of positives; solid growth, tax reform-- a business-friendly environment, deregulation, earnings growth. The list goes on and on.
Q: Any clouds on the horizon for the U.S.?
A: There are indeed a number of concerning developments out there. The Fed is tightening liquidity – raising interest rates, and draining the balance sheet. The yield curve is flattening. The long end of the yield curve has actually seen yields fall throughout the year in 2017. Arguably, that's the bond market questioning if better growth is coming. In addition, credit fundamentals have deteriorated. By Moody's own proprietary measure, covenant quality is at the lowest level on record. Meanwhile, inflation-adjusted yields on Treasuries are paltry, and credit spreads are very tight, although above their historic lows.
Q: So with this kind of a backdrop, how should we think about rates and credit in the U.S. in 2018?
A: We view U.S. high-yield as the best house in the more challenging neighborhood of the fixed income market. So, our exposure in fixed income has been much more focused on opportunities in the high yield segment. As highlighted, with stronger economic growth, but very modest inflation and limited average hourly earnings growth, we would expect at some point in 2018 for safe-haven yields, that is treasury yields, to rise.
That would generate negative returns in the investment grade segment, given that spreads are now through 100 basis points. So, high yield with a risk premium of around 370 basis points looks like a reasonable way to capture yield and immunize yourself from sensitivity around interest rates. And if you believe in contingent claims valuation models, the sensitivity to equity markets which continue to rally provides a lot of protection.
There’s a portfolio benefit as well: in owning high yield, one is able to be more correlated to the movements in the high yield space.
So, with the real risks in the credit markets in the U.S., lower covenant quality-- certainly tighter spreads, the potential for rate normalization and a potentially inverting yield curve, we continue to believe that high yield spreads can grind tighter throughout 2018.
Q: What about credit within high yield?
A: We believe that in the latter portion of 2018 one will need to look a little bit more conservatively at the high yield space. In preparation, we’re favoring is upgraded quality, focusing largely on double-B, single-B credits, and de-emphasizing the most speculative-- weakest covenant quality, most leveraged areas. We're preparing for that potential more significant spread widening in later 2018.
Q; Moving to Europe, what are you seeing?
A: Amazingly, ten-year German bunds yield about 30 basis points, yet nominal GDP in Germany is north of 4%. The European high yield index yields about 2.7%, a mere 30 to 40 basis point pickup on the ten-year U.S. Treasury.
Clearly, there are some very big distortions going on in continental Europe with the type of asset purchases that the ECB is doing. And many of those distortions are spilling over beyond continental Europe, to other developed bond markets. On one hand, the European economy is very strong. PMIs are at multi-year highs. Consumer confidence has come back. But the European Central Bank (ECB) is tapering, and political risk remains elevated, especially with Italian elections coming up in the spring.
Q: So how should we think about Europe in 2018?
A: We have a real simple answer. We simply stay away. We have no interest in the sovereign bond markets in Europe. And in fact, we're stepping away from interest rate sensitivity, thinking about the short side instead. We have no interest in credit spread in those markets either.
We view the set as overvalued. In essence, the investment-grade and high-yield markets in Europe look to us simply like interest rate plays. And as the ECB begins to taper and normalize interest rates, admittedly after the Italian election-- we believe that you'll see yields rise and spreads widen, because of the technical influence or impact that they've had on the market. So, our approach has been to favor the U.S., to favor other regions of the world, and to immunize from any of the effects of rate normalization in continental Europe.
Q: What do you think right now about Asia or Latin America, and emerging markets in general?
A: We've had a generally very positive view on emerging markets throughout 2017, and we currently expect that perspective to be maintained throughout 2018. In essence, what we've liked is Latin American exposure, as well as very specific exposures in Asia.
In the Latin American space, Brazil, Argentina, and Peru, both in the local currency and in the corporate markets, we saw a very cheap basis, probably the cheapest valuations of any markets globally. So opportunities, whether in the corporate space or local currency, sovereign bond space, particularly in Brazil, have been a big part of our preferences in the credit-oriented space. We expect this to continue throughout 2018. We've favored Peru and Argentina – local currency and sovereign space – as well, and that’s been a solid call so far. There are some challenges with respect to Argentina, given some of the political volatility.
Q: How about Asian EM?
A: In Asia, we've really focused on what we view as a gradual recovery as well as improved stewardship in Indonesia. Local currency sovereigns have been very positive and offer high real yields. So from our perspective, emerging markets in lieu of European credit risk has been very favorable in 2017, and should again be so in 2018.
Q: So far, you've highlighted some of the positive segments of the global bond market. We've also touched on some of the specific areas of concern. But where do you see the biggest overall risks for 2018?
A: There are several key risks in the credit markets. Focusing first on risks in corporate credit, a key risk is the lack of covenant quality – higher leverage, or the higher “attachment point”. That last item is our term for the debt to EBITDA ratio. Investors are now willing to lever companies up to a greater degree, and are receiving less compensation, in the form of covenants, for taking that risk. That's a worry typical of late-stage credit behavior, or credit underwriting behavior.
The second risk – this is foreshadowing of weaker economic growth – is the potential inversion of the yield curve. We've seen very significant flattening in the U.S. Treasury curve in the fourth quarter of 2017. Typically, that serves as a forecast of the potential for a recession.
If you look at the “Shadow Fed Funds rate” developed by the Atlanta Fed, at one point it reached a Fed Funds shadow rate of negative -3%. Today, we're between 1.25% and 1.5% -- that’s after the most recent Fed rate hike here in December. So in effect, we've had four plus percent of rate tightening, if you will, when one accounts for balance sheet, expansion, and now rate normalization.
That can typically cause a recession, and the fact that the yield curve is now trying to invert worries us as well. So, what we need to watch out for is the potential for significant spread widening, and we think that could start to happen later in 2018. We anticipate default rates will hit a low of about 1.5% in the middle of 2018, and then climb to about 2% by the end of 2018.
Q: And the impact?
That upward revision – along with the elevated level of default rates– typically leads to wider spreads. What we're doing now is favoring upgraded quality, considering opportunities in emerging markets, reducing interest rate sensitivity with the expectation that central banks will continue to normalize rates, and also preparing for an eventual uptick in the default cycle.
Q: Thanks, Gary and Brian