In a piece published in Portfolio Adviser, Church House joint CIO Jeremy Wharton gives a detailed assessment of credit markets

In the face of Brexit confusion, 2019 may not be a good year to attempt annual predictions. If some kind of workable withdrawal agreement is ratified, most likely involving an extension of the timeline, or another alternative emerges, then there may be enough clarity for forecasting.

A ‘no-deal’ exit would unsettle (or panic) many businesses. Whichever way people voted in the referendum, it was not to find themselves in the current situation. The never-ending ‘B-word’ worries continue to weigh on sterling and, unsurprisingly, confidence in some UK corporates and their credit is fragile.

The cost of borrowing for these companies is rising, however this plays out, and this is not a cost that is represented in headline inflation numbers.

Governor Carney has repeatedly appeared in front of the Treasury Select Committee to warn of risks and potentially higher rates – but still no one seems to be listening.

The cost of insuring UK debt through sovereign credit default swaps has climbed to levels not seen since mid-2016. Despite this, the UK economy chugs along with fairly solid, if unspectacular, growth rates although reduced business investment does not bode well.

Weak manufacturing and industrial production numbers are countered by strong service sector growth. However, inflation remains just above target and with employment levels at around full capacity, wage inflation is beginning to feed through.

Liquidity and volatility

Away from the UK and Europe, other leading economies – the US, China, Japan – barely have Brexit on their radar but still have plenty of worries. Even if there is a slowdown in 2019, the OECD is still forecasting global growth of 3.5%.

We are optimistic that Q4 2018 volatility contained the worst of the global derating of risk assets (93% of risk assets performed negatively over 2018, according to Deutsche Bank) but remain wary as central bank quantitative tightening is with us.

The Federal Reserve is rightly continuing to shrink its balance sheet, while possibly showing some flexibility over the pace of rate hikes. The Trump administration suffered more high-profile departures but Jerome Powell remains in place and not focused on equity indices.

Although the European Central Bank has already begun to rein back asset purchases, attempting to wean markets off the situation it created, this has barely started. There is a long road ahead and we fear the withdrawal of liquidity will lead to further bouts of volatility.

Globally, tightening credit conditions and the reversal of the liquidity story underpinning credit spreads prompted nothing but widening all last year.

The iTraxx Europe Main Investment Grade Index started the year at 45 and ended it at 87, the iTraxx index of crossover credits (investment grade to sub-investment grade) has widened from 233 to 352 and there has been precious little stability so far this year. December was one of the quietest on record for investment grade issuance.

Big issue

The primary market has had an active start to 2019 but only with issuance from sovereigns, supranationals and agencies (who usually have a busy start to the year) or higher-grade issuers.

Unlike most of 2018, when just about any issuer could come to market and easily raise funding at terms advantageous to them rather than the investor, these have needed to offer generous new issue premiums.

The high yield market closed in December with not a single new issue printing. The leveraged loan market, one of the hottest parts of credit markets earlier in 2018, followed the usual course of reducing yields, covenants and credit quality until the market balked, it too effectively closed for new issuance.

These loans had been in demand as retail investors indiscriminately searched for yield packaged up as collateralised loan obligations (CLO), a record $127bn issued in 2018, but CLO issuance has shrunk rapidly and suffered significant price declines since.

As the complacency around credit risk vanished, many factors combined to inject volatility into credit sectors, and specific stories have started to emerge.

Ten years ago, GE was one of the small, select number of AAA-rated corporates. It has now just been downgraded further to BBB+, signifying a dramatic fall from grace.

GE Capital UK Funding has £4bn in sterling liabilities and even its sub-two-year issues are nearly 4% over equivalent gilts. This time last year that spread was around 0.6%.

The once mighty Pacific Gas & Electric Co, hit hard by potential wildfire liability claims, now trades as junk and looks likely to file for Chapter 11 bankruptcy protection. While it has no euro or sterling-denominated bonds, it has $21bn outstanding in dollar debt issues.

Fall from grace

The trend of lower-grade issuance has led to an overall degradation of the quality of the stock of credit risk, and, as ever, the weakest credits have been hardest hit as a result of volatility.

A recent study from Moody’s analysed the quality of outstanding liabilities across the credit spectrum and concluded that such an “unprecedented amount of BAA-grade bonds menaces the credit outlook”.

From a dollar perspective, the amount of BAA-rated corporate bonds is now around $2.83trn, versus $2.62trn of single-A corporates and only $629bn of AA or higher, meaning the US investment grade corporate bond market, from a ratings view, is the riskiest it has been since 1981.

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