Portfolio Manager David Milward shares his thoughts for 2021.
- With Covid‑19 vaccinations ongoing, the prospect of a return to more normal levels of activity in the economy has risen, and with it the expectation that it could drive a general improvement in corporate credit.
- A positive surprise has been the low levels of defaults in loans in 2020 despite the massive shock to the global economy.
- Analysis of loan spreads over the last 20 years, reveals that spreads have been tighter than current levels around 50% of the time. We do not expect any change in this dynamic.
A return to more normal activities?
Covid‑19 vaccination programmes in Europe and around the world have brought the prospect of a return to more normal levels of activity in the economy. This has bolstered credit markets as investors look ahead to the world emerging from the grip of Covid‑19, which is likely to drive a general improvement in corporate credit quality. The expectation of better times ahead, fuelled by a strong tailwind from seemingly endless central bank liquidity, has meant yields have continued to depress and the percentage of fixed income assets delivering below 1% yields has continued to grow. Hence, investors looking to generate real returns have had to look lower down the credit spectrum.
As we started 2021, loan spreads remained wider than their pre‑pandemic levels (the three‑year discount margin for the market stands at 459 basis points (bp) versus 406bp at the end of 2019), in part reflecting the fact that the average market price is 100bp lower, a year on.
Looking back at the last 20 years, loan spreads have been tighter than current levels roughly 50% of the time, and as shown in chart 1, this makes them look attractive relative to other fixed income asset classes).
Chart 1: long‑term relative valuations — spread ranges, percentile rank (current versus history)
Source: Janus Henderson Investors, Bloomberg, Credit Suisse, JP Morgan, as at 31 December 2020.
Note: Data range is 20 years. Index data is for illustrative purposes only and not indicative of any actual investment. Indices used: US high yield: ICE BofA US High Yield Index; EUR high yield: ICE BofA European Currency Non-Financial High Yield 2% Constrained; US Loans: Credit Suisse Leveraged Loan Index; European Loans: Credit Suisse Western European Leveraged Loan Index; EM Corporates: ICE BofA US Emerging Markets Liquid Corporate Plus Index; US investment grade: ICE BofA US Corporate Index; EUR investment grade: ICE BofA Euro Corporate Index; GBP investment grade: ICE BofA Sterling Corporate Index; UK RMBS AAA: JP Morgan UK RMBS AAA 5y GBP; European CLOs: based on Citi Velocity European 1.0 AAA CLOs up to March 2013 then European 2.0 AAA CLOs thereafter.
Low levels of default are a positive surprise
In a year of so much upheaval, one thing that positively surprised during 2020 was the low level of defaults despite the massive shock to the global economy. Central bank liquidity injections lowered the cost of funding and allowed companies to continue to raise funds. Business owners and governments also provided capital to meet short‑term liquidity needs and protect employment; thus, secured loan default rates remained low (chart 2), confirming that this is a very different crisis from what the market experienced in 2009.
Chart 2: defaults start from a low base with no material rise anticipated
Source: Janus Henderson Investors, Credit Suisse, as at 31 December 2020.
Note: Index data is for illustrative purposes only and not indicative of any actual investment. US LLI: Credit Suisse Leveraged Loan Index; EUR WELLI: Credit Suisse Western European Leveraged Loan Index.
We do not see any change in this dynamic, which should allay fears of default-linked losses — a primary concern for investors when stepping down the credit spectrum. The ability of companies to refinance, which is linked to ongoing central bank and government support measures, should continue to suppress default risk through 2021 — Credit Suisse are forecasting a default rate of 1.1% and a loss rate of 0.3% for European loans this year*.
* As at 6 January 2021