Credit markets: Q1 2021 in review | Calamatta Cuschieri

The rotation argument, triggered by expectations of less restrictive measures, and the inflation proposition, stemming from substantial stimulus aid and growth prospects, were undoubtedly the key themes of Q1 2021.

Investment grade credit struggled as the U.S. 10-year Treasury yield surged from just below 1 per cent at the beginning of the year, to 1.74 per cent at the end of Q1. The rise in U.S. Treasuries spilt over to Europe. Notably, European and U.S. investment grade produced negative total returns, while high yield corporate credit, except for EM high yield which headed lower, delivered gains.

Rising yields, expectations of substantial fiscal stimulus, and central banks maintaining an accommodative stance drove a rotation further into the previously battered pandemic sectors.

Sovereign yields

Euro Area: The low yielding environment, revolving at levels below the 0 per cent mark, although initially sustained, headed higher. On the back of increased optimism, a sell-off within Eurozone sovereign debt market was witnessed. In February, bond yields pointed higher – increasing the cost of borrowing for governments that continued to auction debt at less favourable levels given the upward tick in yields. The sell-off in European sovereign yields abated in March.

As uncertainty clouded the outlook, Euro area investors were once more seen scrambling for the safe haven of government bonds.

All in all, sovereign yields have in Q1 2021 inched substantially higher. Germany and France’s 10-year benchmark yields rose by 28bps and 30bps, respectively.

U.S.: At the start of 2021, the economic situation – conditioned by the health crisis particularly as coronavirus cases soared to significant highs, was bleak. However, a combination of; the Democrats gaining control of the U.S. Senate and thus paving the way for a substantial fiscal stimulus, higher inflation expectations, and a coronavirus vaccination programme well underway and ahead of schedule, brightened the outlook for the economy per se.

The benchmark 10-year U.S. Treasury yield, which moves inversely to price, and previously revolving below the 1 per cent barrier, drove significantly higher. The U.S. 10-year benchmark Treasury yield ended Q1 83bps higher at 1.74 per cent.

Corporate credit market

In Q1 2021, corporates within the investment grade space were largely conditioned by the upward moves in benchmark yields, namely U.S. Treasuries. High yield issuers, except for EM high yield, delivered gains.

U.S. investment grade realised a loss of 4.49 per cent in Q1 2021. Meanwhile, European and U.S. high yield have, over the stated period, remained largely consistent, generating total positive returns. European and U.S. high yield names returned 1.55 and 0.90 per cent, respectively. Albeit pointing higher in February, EM high yield remained largely conditioned by the lingering uncertainty surrounding the pandemic and vaccination programmes, or the lack thereof, losing 0.83 per cent over the period.

Sector analysis – High yield market

All sectors have in Q1 2021, generally, witnessed credit spread tightening. Rising yields, expectations of substantial fiscal stimulus, and central banks maintaining an accommodative stance drove a rotation further into the previously battered pandemic sectors. The sectors more sensitive to economic recovery outperformed.

Services: While the manufacturing sector showed remarkable resilience during a year characterised by movement restrictions and thus social disruption, services – reliant on direct contact, suffered. However, a coronavirus vaccination drive, easing of lockdown measures, and recovering confidence among clients, instilled optimism.

U.S., European, and EM high yield names within the services sector witnessed spread tightening in Q1. EM issuers outperformed with credit spread tightening of 124bps.

Retail: Albeit showing signs of improvement when social distancing measures were lifted, retail sales have largely remained depressed. With the ongoing vaccination drive, retail – a contact intensive service sector is expected to witness a revival. Savings rate, which has largely remained elevated during the ongoing health crisis shall further bode well for the retail sector, should it subside to pre-pandemic levels.

European and EM issuers witnessed a credit spread tightening of 138bps and 224bps, respectively.

Transportation: Although severely hit by the pandemic, efforts made by issuers, in terms of capacity management, cost reduction and other operational decisions, allowed them to survive. Ensuing such difficult period, an improvement in industry metrics such as airline’s ‘load factor’ and shipping ‘freight rates’ instilled optimism.

In Q1, U.S. high yield names within the transportation sector recorded credit spread tightening of 224bps. 

Outlook

We believe that although the rise in sovereign yields, in expectation of an uptick in inflation was warranted as both fiscal and monetary stimulus remain in play, market participants might be too optimistic when considering the recent moves, namely in the U.S. sovereign curve. Particularly as the extent of a recovery in the real economy remains, to-date, unknown.

An inflation spike is probably inevitable as lockdown restrictions ease. However, this might also be conditioned by the base effect.  As the economy normalizes, we expect the Fed, to be willing to accept modestly higher yields, but would move quickly to quell an acceleration in a Treasury sell-off.

We remain constructive within the high yield space, and more specifically on sectors that should recoup strongly as normalisation continues its upward trajectory. Moreover, the idea of improved credit metrics, as the economy recoups, might pose an opportunity for very diligent bond picking in selective credit stories that hold the possibility of a rating upgrade. Recent market disruptions may offer pockets of opportunities, with selective sectors being good candidates for portfolio positioning.

Disclaimer: This article was written by Christopher Cutajar, Credit Analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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