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Weekly credit insight

Chart of the week: navigating the sell-off in credit markets

The current shakeout in credit markets is occurring at an unprecedented pace. Historically, it has taken longer for credit spreads to adjust to market turmoil. But the perfect storm created by the spread of Covid-19 and the failure to balance oil markets has made it harder for markets to react as they did in Q4 2018, when a swift response from central banks led to a strong snap back the following quarter. Figure 1 shows how the widening of credit spreads during the current sell-off has been faster than in any other market drawdown over the past 18 years.

Figure 1. Credit spreads: a rapid unwinding 

Source: Federated Hermes, ICE bond indices, as at 18 March 2020.

This time round, the policy response is more powerful and widespread. However, given the nature of the problem, at best this should only stabilise markets. All the steps taken should support the global economy, but it will take time for confidence to recover – which in turn is dependent on the trajectory of Covid-19.

Markets have also become increasingly challenging to navigate, particularly for investors that use government bonds as a hedge. Recent moves indicate that there is uncertainty about the impact of a debt-funded fiscal spending on the cost of debt for European economies.

Looking back to credit, some parts of the market are trading at almost the widest level in 10 years. Indeed, US high-yield credit is its highest point seen over the past decade (see figure 2).

Figure 2. High-yield credit spreads soar amid the volatility

Source: Federated Hermes, ICE bond indices, as at 18 March 2020. 

Opportunities do exist amid the turbulence. B- and CCC-rated credits have outperformed expectations due to the superior liquidity in higher-quality credit, while the poor performance of larger capital structures and liquid parts of the market can be seen through the underperformance of credit exchange-traded funds.  

As the focus moves away from liquidity management to the higher risk of irrevocable capital losses, decompression will accelerate. Support from the European Central Bank has helped European investment-grade credit hold up better than its American counterpart. US investment-grade credit now seems attractively valued, given that the US dollar remains the key reserve and safe-haven currency – something that should support demand for dollar-denominated fixed income.

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