Opportunistic Credit Rally Likely to Continue
Opportunistic credit can continue to climb, given the synthetic impact of central banks
Low interest rates are here to stay, creating a vacuum for risk compensation
Structured credit will perform well and is likely to lead opportunistic credit asset classes
The March 2020 market sell-off now seems distant and is squarely in the rear view mirror, erased by a relentless advance across credit markets. From the trough, U.S. High Yield1 climbed 33.5% and was positive for 2020, rising 7.11% and eliminating the 20.78% virus-induced drawdown. It is natural to doubt this rally’s sustainability, but the upward trajectory remains intact, especially in less travelled areas of the market. Nonetheless, returns hinge on the battle to quell the virus and the fallout from tools utilized to stabilize the economy.
This rally can continue, primarily based on the lack of yield available in high-grade bonds. Interest rates2 across G7 countries average 22 bps, and global negative yielding debt3 remains near its all-time high of $18 trillion. It makes sense to question the sanity of low yields and the obvious risk of a trend reversal in the 30-year bull market for rates. Yet “sanity” and “obvious” are not temporal measurements, and rates are likely to remain low as global central banks double down on their commitment to market stability and low borrowing costs. This creates a vacuum for compensation paid to high yield investors, and we believe the risk premium will continue to shrink, potentially falling below historical averages. We also expect increased flows into high yield asset classes due to low return assumptions for high-grade debt. This reflects a behavioral shift and a reluctant, but crucial, embrace of higher volatility within portfolios.
Lower-rated debt and equity within structured credit represents the best reward potential in 2021. Collateralized Loan Obligation (CLO) issuance is set to outpace 2020, with estimates as high as $120 billion4. The market is also likely to see additional cash flow as the pace of rating downgrades slows and the underlying loan market recovers to pre-pandemic levels. Yields remain above 7%5 in BB-rated tranches, and equity returns could approach double-digits. Traditional U.S. High Yield is also likely to perform well, owing to Federal Reserve support and high liquidity within the asset class. We expect opportunistic credit markets to provide returns between 4%-6%, on average.
1Bloomberg Barclays US High Yield, LF98TRUU
- Trough: From 3/23/20 – 12/31/20
- Drawdown: From 2/20/20 – 3/23/20
2Bloomberg Barclays Global G7 Yield-to-Worst, LGG7YW (as of 12/31/2020)
3Bloomberg Barclays Global Agg Neg Yielding Debt Market Value, BNYDMVU
4“CLO Credit Lines Surge as Market Readies for Record January” – Lisa Lee
5Palmer Square BB CLO Index, PCLOBBYD