Weekly Bond Bulletin

24 September 2020

Buy the dip?

Risk markets marched higher over the summer, but now that the recent period of low volatility returns has come to an end, could a widening in high yield bond spreads represent a buying opportunity?

Fundamentals

Rising Covid-19 infection rates in Europe have triggered new social distancing measures, most notably in Spain and the UK. The US may soon have to follow suit, with case counts also picking up again. The latest local lockdowns and curfews are not as draconian as the measures put in place earlier this year, but they have contributed to lower growth forecasts for the fourth quarter compared to the third quarter. According to Bloomberg, US GDP growth forecasts stand at 25% for the third quarter (quarter on quarter, annualised), declining to 5% for the fourth quarter, while forecasts for Europe are 34% and 10% respectively. Although a slowdown is to be expected, GDP growth is expected to remain significantly above trend, which is generally agreed to be around 1.75% for the US and 1% for Europe. Crucially, significant fiscal and monetary support has kept distress low and we do not expect a radical shift in central bank policy in the coming months.

Quantitative valuations

Until now, the third quarter had been characterised by low volatility and a gradual grind tighter in high yield spreads. However, more recently, risk assets have witnessed a correction, led by equities. High yield spreads have held up better, but US spreads are still 40 basis points (bps) wider at 453bps, while European spreads have widened 9bps to 462bps. This recent back up in spreads could provide an opportunity to earn carry in a zero interest rate environment. (All data as of 21 September 2020).

High yield returns have outperformed equities on a beta-adjusted basis in the recent sell-off

Source: Bloomberg (SPX Index, SXXP Index), ICE BofA (HUC0 Index, HECM Index). Data from 31 August 2020 to 21 September 2020. *Beta for HUC0 to SPX YTD is 0.46 and beta for HECM to SXXP is 0.34.

Technicals

Investors have been momentarily spooked by the recent flare up in risk markets. US high yield exchange-traded funds (ETFs) were subject to outflows of $1.3 billion on 21 September and $1.6 billion on 22 September—the biggest exodus since February. However, outflows from actively managed US high yield mutual funds have been much lower (-$140 million on 22 September), suggesting that the ETF outflows have been driven by fast money reacting to the recent volatility. Therefore, with demand for yield still overwhelming, we believe that recent outflows are likely to prove to be a temporary clearing out.

What does this mean for fixed income investors?

Volatility has surged again in risk markets in recent weeks. Although equities have suffered the most, high yield spreads have also widened. However, despite recent outflows, we expect the current weakness in high yield to be short-lived and much less severe than in the first quarter, as central bank policies continue to provide strong support for credit markets. As a result, any further back-up in spreads could provide an opportunity for investors to add exposure and lock in some carry as they continue to search for yield.

About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Click here to read more about our FQT capabilities


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24 September 2020
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