What’s ahead for credit market?

Credit spreads widened quite sharply over the past month, given a more hawkish tilt by the ECB that leads us to believe its corporate bond purchases could be adjusted downward in Q2.  This followed an earlier announcement that the Fed will move faster on QT after a March rate hike. Meanwhile, benchmark yields have also edged higher YTD.

Hence those negative total returns (-3.4% for EUR IG YTD, -3.2% for EUR HY) will likely translate into funds outflows, which will add to the selling pressure. That being said credit has been resisting better than the rest of the fixed income space which could mitigate the appetite for reducing credit in global allocations. The other components of technicals will also help with 1/lower supply: Issuances have been strong in January, but we believe that overall they will remain inferior to 2021 levels by more than 10% in Euro IG, as cash on the corporate balance sheet remains at a record high and 2/ still elevated ECB purchases as long as QE is running, up until August in our central scenario.

Higher interest rates will not challenge corporate fundamentals near term. Corporate earnings in Q4 remained strong despite a multitude of inflation headwinds. The reporting season will continue to provide support, with Banks, Energy/ Materials showing particularly strong increases in Earnings. Although the pace of deleveraging has slowed, corporate balance sheets remain strong. The risk is given still plentiful liquidity, corporate re-leveraging could pick up, but we believe this should be manageable. We expect the default rate to remain below 2% in 2022, well below the pre-pandemic level of 3.3%. Similarly, we will continue to see more rising stars than fallen angels, and more upgrades than downgrades although the trend will be less strong than in 2021.

Volatility in the credit market will remain elevated in the coming weeks but we consider that current spread levels incorporate the tapering of the CSPP mid-2022. Hence we expect broadly flat credit spreads on average into year-end. In 2018 credit spreads widened by more than 80bps on the tapering but also on a very bad macroeconomic landscape. This time is different the macro environment is far more supportive and credit spreads are highly correlated to the cycle. Furthermore, ss mentioned by Schnabel on Twitter last week reinvestments of both PEPP and APP can be flexibly allocated, meaning that the ECB could remain a net buyer of credit after the tapering if needed. 

We remain neutral IG vs. HY as we believe the higher beta of high yield will be counterbalanced by its higher carry and shorter duration. Despite the negative technical of the CSPP tapering we continue to prefer EU vs US credit on slower monetary policy normalisation. We move overweight financials versus non-financials on the expectation that non-financials will no longer receive the direct support from the ECB buying, while financials will largely benefit from higher profitability induced by higher rates. We continue to favour credit risk to duration risk obviously in this context and prefer BBBs, BBs corporate hybrids and AT1s.