• September is likely to be the worst month of the year thus far for returns.
• Without credit inflows resuming we fear spreads can only make shallow gains by year-end, absent big corporate bond QE.
• Watch EM exposed "outperformers" and credits with steep front-end curves.
A bull market in "fatigue"
Month-to-date, investment-grade cash bond spreads are 21bp wider and high-yield cash bond spreads are 73bp wider. September is shaping up to be the worst month of the year for performance, and the year-to-date picture is no rosier. Events have, of course, been numerous this year, and September has been about auto scandals, but underneath the surface there are signs that the monetary policy backdrop in Europe is creating a bull market in "fatigue" and a bear market in credit performance.
Contagion and catalysts
The gap wider in European credit feels like a buying opportunity. But we’re not sure that the market can post much in the way of a rally by year-end. Inflows remain the credit market’s "glue" and for now they are absent. Money, instead, is gravitating towards equity income. Absent credit inflows, we see the new issue machine in corporate bonds constantly repricing secondaries.
The case for a big rally rests on the ECB buying a much greater array of corporate bonds, rather than just a handful of names. Arguably, with the credit market showing signs of dysfunction in new issues, the logic for central bank purchases of corporate bonds has never been stronger.
Why isn’t QE "working" in credit?
2015 has been a year where the ECB has kept interest rates below zero, embraced QE, and is likely to extend it further by year-end. And yet, investment-grade excess returns have been positive in only three months of the year. Ironically, while monetary policy is supporting the economic recovery, it has created mixed fortunes in the credit market. Liquidity, flows and event risk are all areas that are currently suffering in credit, and we sense that central bank policy is exacerbating some of this.
What to watch: EM exposure and the laggards
In illiquid and volatile times, spreads across the market are rarely priced consistently. EM and China sales exposure are two such examples. Our scatters show that there are plenty of names with relevant EM sales exposure, where spreads have barely moved, if not tightened, since the end of August.
What to watch: Front-end weakness
The high-level of idiosyncratic risk at present, coupled with a patchy new issue market, points to weakness in the front-end of the credit market over the weeks ahead. Glencore’s CDS curve, for instance, is now heavily inverted. We highlight investment-grade names that still have some of the steepest 3s5s CDS curves. We think flattening pressure will be the theme going forward.
