Credit Markets: Q3 2021 in review | Calamatta Cuschieri

Policy action by the respective central bankers, sustainability in economic momentum, and inflation proposition - stemming from a reopening of economies, supply bottlenecks, and a commodity super-cycle, were undoubtedly the key themes of Q3 2021.

The role of central bankers and governments, have since the coronavirus pandemic broke, been crucial. In response to the ensuing economic disruptions, policy makers intervened, introducing from a monetary policy perspective; interest rate cuts and bond purchasing programmes. Governments, albeit generally constrained in terms of fiscal space, swiftly reacted, introducing fiscal stimulus. Monetary intervention allowed corporates to tap the primary market at low favourable rates while fiscal intervention allowed corporates to maintain their cash buffers and ultimately survive. The latter at the expense of increased debt levels.

Sovereign yields

Euro area: European sovereign yields have in September pointed higher, reversing some of the downward moves envisaged since the end of Q2 2021, as economic activity maintained its recent robust pace. The single currency bloc continued to benefit from the release of pent-up demand, having come out of coronavirus-inflicted restrictions relatively late.

Early in September, as the strong rebound in economic growth and inflation started to materialize, the governing council of the ECB decided to slow the PEPP - the ECB’s flagship policy response to the pandemic. The asset purchase programme - an important tool for central banks to secure price stability in the vicinity of the zero-lower bound, had since March run on €80 billion-a-month level. Also, European Central Bank policy makers signalled they see Euro-area inflation potentially exceeding forecasts as the economy recovers and supply bottlenecks drive up input prices. The euro area is currently enduring the fastest price increases in a decade, with a rate exceeding the 3 per cent mark. ECB President Christine Lagarde affirmed that the spike in inflation is largely transitory.

Yield of the 10-year German Bund, closed the quarter marginally higher at -0.20 per cent from -0.21 per cent at the end of June. Earlier in the quarter, the yield on Europe’s most sought-after benchmark had touched six-month lows of -0.52 per cent amid concerns over a weaker global economic outlook due to coronavirus outbreaks.

U.S.: U.S. Treasury yields have over the month of September continued to retrace some of the significant downward moves witnessed in recent months, then influenced by investors beginning to doubt whether economic data, notably the upticks in inflationary figures would continue to advance or else prove transitory. 

In Q3, the Federal Reserve (Fed) became increasingly hawkish suggesting that stimulus, notably asset purchases could start being reduced as early as November and possibly be wound up by mid-2022, earlier than initially anticipated. Following such signal, the yield on the benchmark 10-year Treasury note soared to the 1.50 per cent levels, from a low of 1.29 per cent. 

The benchmark U.S. 10-year Treasury yield, closed the quarter 2bps higher at 1.49 per cent, when compared to the previous.

Corporate Credit Market

In balance, Q3 2021 proved positive for the corporate credit market.

Investment grade bonds were little changed, while high yield corporate credit, with the exception of EM high yield – the laggard for the quarter, generated total positive returns albeit reversing some of the gains witnessed.

In Q3, EM high yield corporate credit edged significantly lower. Regulatory actions in China - an important player in EM corporate credit, were the initial trigger for market weakness. Market jitters were then amplified by the re-imposition of some coronavirus-inflicted restrictions leading to global supply chain disruptions, worries about possible systemic financial system risks stemming from the potential collapse of Evergrande - the country’s second-largest real estate developer by sales, and an intense energy shortage in the country.

Over the stated period, European investment grade saw a return of 0.07 per cent, while U.S. investment grade lost 0.06 per cent. In the more speculative segment, U.S. corporate credit outperformed its European counterparts, registering a return of 0.94 per cent against a 0.69 per cent gain.

Sector analysis – High yield market

From a sectorial perspective, the scenario was largely mixed, with sector specific and geographical issues seemingly dictating overall performance.

Real Estate: The dollar-denominated Chinese credit market, for quite some time posing as an attractive opportunity to investors in search for a higher yield, have in recent weeks, consequent to policy changes - introduced by the CCP and set to improve financial health for the real estate sector, built a narrative that a wide swathe of Chinese assets are under threat.

Heightening pressure on the Chinese credit market was a cash crunch at China’s Evergrande Group – one of the largest Chinese property developers, which stoked contagion fears in the sector. Consequent to the contagion fears, EM high yield names within the real estate sector saw a widening in spreads in July. Albeit reversing in August, the downward trend restored in September as Evergrande Group missed a bond payment deadline.

Inevitably, EM high yield underperformed, with the sector witnessing credit spread widening of 748bps.

Energy:  Fuelling inflation worries, amongst the transitory effects following the reopening of economies, were energy prices.

Crude oil, strongly depressed at the peak of the health crisis and ensuing mitigation procedures giving rise to reduced demand, has in 2021 recovered strongly. The re-opening of economies, following a decline in infections and coronavirus vaccination programmes being well-underway, boosted hopes for a sustained recovery in economic activity and energy demand. Crude futures traded above $75 a barrel towards the end of September, the highest since 2018 amid expectations that tight supply and strong demand may continue to support prices in the near term. Oil has also benefitted from the soaring prices of natural gas and coal, making it more attractive as a fuel for power generation.

In Q3, European and U.S. high yield names within the energy segment recorded credit spread tightening. U.S. corporates outperformed, registering a gain of 36bps. 

Transportation: The outlook for the transportation sector, previously conditioned by coronavirus-inflicted movement restrictions and now aided by the normalisation proposition, improved. Surely instilling confidence in the sector, specifically in shipping segment, was a surge in demand.

An industry that initially seemed to be sailing in treacherous waters have, since the coronavirus pandemic broke, navigated well. This, notwithstanding the challenges faced.

The health crisis and ensuing restrictions on movement to mitigate the spread, resulted in a shift of retail consumption in favour of goods rather than services. This, notably supported by the development of e-commerce. Consequent to this shift, the demand for transport and logistic services recovered quickly from the trough levels witnessed in Q2 2020. Shipping liners have been operating at full or quasi-full capacity ever since. Increased demand combined with the disruptions relating to the pandemic have created a severe congestion in global supply chains. In container shipping, this translated into slower asset rotations and severe capacity shortages.

Expectations for liners 2021 full year financial results are highly anticipated, with optimism. Seasonal trends, tight market conditions, recovering economies, stimulus measures, limited available containers, and port congestion shall keep rates above historical levels.

In Q3, European, U.S., and EM high yield names within the transportation sector recorded credit spread tightening. European corporates outperformed, registering a gain of 22bps. 

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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