By Bernard Lalière,
Head of Credit


Being stuck in cars for hours with children, it’s not an uncommon experience for parents travelling during the summer. It can be a nerve-wracking experience, especially if the kids ask, “Are we there yet”?

Nowadays, with the existing tools, it becomes easy to estimate the travel time and to be informed of the roadworks you will encounter. Yet, each time, impatience prevails, and the question comes back.

There are no clear-cut answers to that question, the travel to the destination can be bumpy with a series of unpredictable events that can influence the time of the journey and its duration. Investors are faced today with a similar question: “Are we there yet”, “Is it time to buy”?

A year ago, credit spreads started to widen both in the investment grade and high yield markets. On September 17, the Bloomberg Barclays Corporate Average spread was at 83 bps while the Bloomberg Barclays High Yield, non-financials spread was at 269 bps. What’s started to be, at first sight, an overdue correction in a tight market, is now proving to be a serious correction with spreads more than twice their tightest level of September 17.

Are we there yet, with spreads on European investment grade at 221 bps and high yield spreads at 606 bps?

Like riding a car, investing in credit is not without risk. Default risk is the first thing that come to mind when talking about corporate bonds. If we focus on the market most sensitive to that risk i.e high yield for that analysis, we can accurately estimate the default rate expected at present. Currently, considering a recovery rate of 40%, market expects 36.77% of default for the next five years. The worst period for default in European high yield was during the bursting of the internet bubble. During that period the cumulative default rate reached 30%. However, if one expects a normal recession, default rate is close to 15%.

Alongside the default risk, other risks exist, such as the downgrade risk and liquidity risk which justify additional remuneration of the investors. This is what we can call the market risk premium. On average, the last twenty years, this market risk premium is close to 290 bps in the high yield market. If the market is experiencing, next year, a default rate at 2.5%, the current buffer is 429 bps.

Investing is a journey through an uncertain world but just as the motorist cannot stand still, the investor cannot stand on the sidelines forever. However, in an uncertain environment, caution prevails. Finding the right balance between risk and return has never been more topical than now.

This year, significant changes in interest rate have led to an increase in bond volatility. In the past year, the terminal rate has been revised upward. In the US, currently, the terminal rate is at 5%, 3 months ago, it was 1.5% below. Are we there yet?

Among less volatile investment strategies are the short-dated ones. Combining short duration and a decent carry makes short duration high yield strategies an appealing solution to find the optimal balance between risk and return. This asset class has always been less volatile than traditional high yield strategies given the lower duration and better quality of the underlying credit.

Recession is a high-risk event in Europe, therefore inevitably default rates will increase but contrary to what many think, it’s not among issuers who will refinance soon that the bulk of defaulted companies will be. In the high yield markets, most defaults occur in the first three years of debt issuance and inability of coupons payment is the major cause of default not refinancing risk. Newly issued debt is precisely the area in which the strategy is not present. By focusing on bonds, that have a remaining maturity of maximum four years and that have been issued already for some years, the default risk is drastically reduced.

  Marketing communication. Investing incurs risks. Past performances do not guarantee future results.


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