We see improving outlook for credit – with unprecedented policy action to limit the coronavirus shock in place and sharply lower valuations. Major developed market central banks have committed to keep interest rates low and greatly expanded their balance sheets. This underpins demand for corporate bonds and selected sovereign debt. We upgrade our view on global investment grade credit to a modest overweight from underweight and keep high yield credit as an overweight.
Global central banks have focused on alleviating the dysfunction of market pricing and tightening of financial conditions. The European Central Bank (ECB) has lifted the 750-billion-euro cap on its Pandemic Emergency Purchase Program (PEPP), paving the way for potentially unlimited asset purchases. The Fed has adopted a “whatever-it-takes” approach, including a commitment to massively expand its $4.5 trillion balance sheet, lending programs to directly support small- and medium-sized businesses, states and municipalities, and buying U.S. corporate bonds for the first time. Central bank balance sheets in key economies have reached $20 trillion, as the chart above shows, and are poised to increase a lot further. We see coupon income as attractive amid record-low interest rates, a stabilization of markets thanks to the policy response and improved valuations after the March selloff. We find this source of income in global investment grade and high yield credit, as well as euro area peripheral government bonds and local-currency emerging market debt.
Overwhelming action by fiscal and monetary authorities helps reduce downside risks to the economy – and the risk of an over-sized spike in credit downgrades and debt defaults, in our view. The risk of temporary liquidity crunches remains as the economic shutdown rolls on, and sectors such as energy face severe challenges due to the collapse in oil prices. Yet overall, we believe the recent sharp widening in credit spreads means investors are to a large extent compensated for taking on these risks. We prefer credit over equities given bondholders’ preferential claim on corporate cash flows in a highly uncertain economic environment.
The history of credit performance during past periods of quantitative easing also supports our view. When central banks step in with massive asset purchases, it tends to dampen volatility in interest rates. We believe we are in a similar situation today: The Fed has effectively committed to cap the upside in long-term bond yields, while expansionary fiscal policy may put upward pressure on interest rates. A relatively stable rate environment has often led to the narrowing of the spread between yields of credit and government bonds – and a rise in prices of credit. It also helps to have central banks as committed buyers of bonds including corporate and sovereign debt.
We have upgraded our tactical view on U.S. Treasuries as an offset to the risks of an increased credit allocation. Yields sit near record lows, but Treasuries are still the highest yielding government bonds in major developed economies. This leaves more room for further yield declines than bonds in the euro area or Japan in the event of risk asset selloffs, in our view. On a longer-term horizon, we recognize the role of government bonds as portfolio ballast has come into question given the lower yield levels and a growing commitment of central banks to keep rates low across the yield curve.
The bottom line
We see coupon income as crucial in an even more yield-starved world. The extraordinary monetary and fiscal policy action is shaping up to blunt the coronavirus shock to the economy and markets – and central banks have stepped back in as committed buyers of credit. This, coupled with substantially cheaper valuations, paves the way for out-performance in carry assets such as corporate debt and euro area peripheral sovereigns, in our view.