Global economic growth gained momentum in the last quarter of 2019, resulting in strong performance for lower-quality credit. This came after the CCC-rated segment of the high-yield market underperformed its expected beta in 2019. Deteriorating earnings growth combined with a pick-up in defaults led to a lack of investor appetite for credits that lack the levers to weather a potential storm.
The economic recovery continued into the first month of the new decade and on a total-return basis CCC-rated credits outperformed those rated BB and B during the first half of January. But with the likely impact of the coronavirus increasingly uncertain, declining oil prices and credit markets hit with record-high supply, investors have since refocused on the higher-quality part of the credit spectrum. This meant that CCC-rated credits significantly underperformed in the last week of January (see figure 1)
Figure 1. Changing fortunes: performance of CCC-rated credits declines
Source: Federated Hermes, ICE Bond Indices, as at January 2020.
Macroeconomic headwinds from China and the looming presidential election in the world’s largest economy should lead to a pickup in dispersion. This year will be one where credit skills matter, as demonstrated by the levels of stress seen in the market at the turn of the year.
A rise in volatility when a large share of the market is trading above call increases the risk of extension. In this rapidly changing environment, investors should stick to the liquid part of the market and take a top-down view of the entire credit spectrum in order to dynamically reallocate capital.