Posted inFixed Income

Valuations hint at credit caution

Credit markets are generally expensive and the upside to returns is limited, according to Axa Investment Managers (Axa IM).
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Investors should be careful not to get carried away with good economic news, perceptions that interest rate increase will be restrained and confidence that other risks are manageable.

“Rich valuations, while not being ignored, are not seen themselves as reason to sell. Yet adding money in some parts of the market today does not look that attractive,” said Chris Iggo, chief investment officer, core investments, at Axa IM.

He believes there is a growing argument for caution, at least with new investments.

“Markets are priced for the continuation of a scenario that could not be better constructed. Investors are living with risks that are seen to be manageable while growth and the technical set-up of our financial system is rewarding capital allocated to risk. They are also sitting on handsome returns,” added Iggo.

While the situation could continue, he doesn’t see a lot of the credit markets offering much. Plus, the cost of underweighting credit at this stage is fairly low.

Riding on high returns

For nearly 18 months, equity investors have enjoyed healthy returns. For example, since March 2020, the annualised price performance of the S&P 500 equity index has been 52%. For the Nasdaq, it has been 70% and for the EuroStoxx, the annualised equivalent price return has been 40%.

“These compare with long-term (since the 1980s) annualised price returns of 9.1%, 11.1% and 4.7% respectively,” noted Iggo.

The story for fixed income has been different. The markets’ returns have been interrupted by the rise in yields in the last quarter of 2020 and the first quarter of this year.

“Yet even here we see total returns of 4.5% from US investment grade credit since February 2020, 11.7% from high yield and 5.3% from global inflation linked bonds,” said Iggo. “These returns are above recent historical averages.”

Rising valuations

From Iggo’s perspective, the macro story is unlikely to get much better. “[There is] strong growth with transitory inflation, still accommodative monetary conditions, net fiscal stimulus in many economies and this all translating to healthy balance sheets in the corporate and household sectors.”

Yet while this outlook is considered positive in how Axa IM assesses risky assets, valuations are seen as rich.

“This is particularly the case in credit markets which currently see spreads at their lowest levels since the global financial crisis,” explained Iggo.

Not only are spreads narrow at the market level, he added, but they are compressed within markets between credit ratings buckets.

For example, as of early July 2021, the spread between the US high yield BB-rated index and the CCC- rated index stood at 369 basis points (bps) – a record low according to the Bank of America/ICE bond index data. The average for that spread since the index was first published a decade ago has been 680 bps; in March 2020 it was over 1,200 bps.

“There is not much dispersion in credit markets, which means alpha generating opportunities are limited,” Iggo added.

Part of the Mark Allen Group.