June 11, 2021
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Insights
Are tight credit valuations justified?
Andrew_Keirle_2_280x280px
Andrew Keirle
Ken_Orchard_280x280px
Kenneth Orchard
Quentin_Fitzsimmons_280x280px
Quentin Fitzsimmons
Ju_Yen_Tan_280x280px
Ju Yen Tan
Saurabh_Sud_280x280px
Saurabh Sud

Global Fixed Income Team

Each month, our portfolio managers, analysts, and traders conduct an in‑depth review of the full fixed income opportunity set. This article highlights a key theme discussed.

Positive tailwinds are providing support, but caution is advised.
KEY INSIGHTS
Credit markets have been remarkably resilient so far in 2021, with spreads tightening even as a fierce sell‑off raged across developed government bonds. In our latest investment team meetings, we discussed the dynamics driving credit markets and whether they will continue.
Global growth recovery supports credit
The stars have aligned for credit markets this year, with positive tailwinds coming from ultra-accommodative monetary policy, expansionary fiscal policy, and improving economic growth. These powerful forces have helped to drive credit spreads in sectors such as US high yield to multiyear tights, leaving many investors questioning how much longer this move has to run.

“There is no reason to panic yet – credit spreads don’t tend to sell off because of tight valuations, but rather because of a change in the macro environment,” said Saurabh Sud, a portfolio manager and member of the fixed income global investment team. Such a change is unlikely to occur over the next few months because economic growth is expected to continue its strong recovery as vaccines are rolled out and restrictions are eased, Mr. Sud added.

Analyzing the premium that investors demand to hold corporate bonds could also provide useful information for what might happen next. Let’s remind ourselves that credit premia can be decomposed into three parts: a pure liquidity component, a pure credit quality component, and a pure market risk component. Given the extraordinary amount of ongoing monetary and fiscal policy support, it could be argued that the liquidity and credit components are likely to remain stable or potentially even compress a bit further from here. Although the market risk premium could increase if there is an unexpected spike in volatility. On the other hand, market technicals are incrementally less positive due to higher supply, as are fundamentals given increased mergers and acquisitions activity and shareholder‑friendly actions.

“Watching economic data will be particularly important as we need to see signs the recovery is sustainable beyond the second quarter…”

Taking all these factors into account, allocations to credit markets still make sense, but we believe that some caution and greater selectivity are warranted given the tightness of spreads. “The risk/reward from holding credit has waned since the start of the year,” said Mr. Sud. He noted that this has led T. Rowe Price to reduce credit exposure in some of our strategies, although he retains a broadly positive bias.

Finding opportunities in convertible bonds

In the current market environment, we have a preference for shorter maturities, greater liquidity, and credits dislocated from fundamentals. In particular, we favor bonds from sectors that have suffered during the pandemic and could potentially be key beneficiaries of economies recovering, such as banking. Liquidity is also important, and in this regard we favor derivative instruments and select names in the technology, media, and telecom sectors that should benefit from regular revenue streams.

The new issuance market is another area to monitor for potential opportunities. There are more complex credit stories starting to come through particularly in European high yield. While these may carry higher risk, they also may offer good long-term value potential; however, credit-intensive research is required to try to identify the successful stories and, just as importantly, the companies to be avoided.

Casting the net wider to find value is also important. “At current spread levels, we have been spending time uncovering opportunities further afield such as in convertible bonds,” said Mr. Sud. Here, we have partnered with our equity and fixed income research analysts to find some convertible debt that potentially offers more appealing upside convexity than the generic standalone bond.

Growth and inflation data key signposts for market direction

There appears to be little that could derail investor sentiment toward credit in the near term. Over the medium term, however, there are key risk factors that should be monitored. “Watching economic data will be particularly important as we need to see signs the recovery is sustainable beyond the second quarter when growth, stimulus, and reopening optimism are all expected to peak,” said Mr. Sud. He warned that this year’s fiscal stimulus tailwind, for example, will likely turn into a headwind in 2022 as spending is reduced and taxes potentially are increased.

If strong economic data are maintained, there is a risk that real inflation pressures will start to build. Under this scenario, the resolve of central banks such as the Federal Reserve to remain accommodative could be tested. “Any signs that the Fed is changing course and moving toward tightening could drive core bond yields another leg higher and negatively impact investor risk sentiment,” noted Mr. Sud. It is unlikely that credit would escape unscathed in that situation, again underlining the importance of watching economic data. 

The equity market could also offer helpful insights into the future behavior of credit spreads, particularly the ratio of US large‑cap cyclical performance to defensives. In the past, new lows in this index have often been a precursor for credit spreads widening. At present, the ratio remains on an upward trajectory – but if that were to reverse, it may be a sign for caution. We are monitoring the situation closely.

ID0004324 06/2021

202106-1668796

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Arif Husain

Head of International Fixed Income
Portfolio Manager, T. Rowe Price Dynamic Global Bond Strategy

Arif Husain is Head of International Fixed Income at T. Rowe Price. He is lead Portfolio Manager for the Dynamic Global Bond and Global Aggregate Bond Strategies. Mr. Husain is also Co-Portfolio Manager for the firm’s International Bond, and Institutional International Bond Strategies. He is a vice president of T. Rowe Price Group, Inc. and T. Rowe Price International Ltd.

Mr. Husain has 24 years of investment experience, six of which have been with T. Rowe Price. Prior to joining the firm in 2013, he spent 14 years as director of both European Fixed Income and Euro Portfolio Management at AllianceBernstein. He was also a member of the global fixed income and absolute return portfolio management teams. Mr. Husain previously worked as assistant director of European Derivatives Trading at Greenwich NatWest and also traded interest rate swaps at Bank of America National Trust & Savings Association.

Mr. Husain received a B.Sc. (hons.) in banking and international finance from the City University, London Business School. He also has earned the Chartered Financial Analyst designation.

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This site is intended for Wholesale Clients. I have read the terms detailed below and confirm that I am a Wholesale Client and that I wish to proceed.

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Information contained in the T. Rowe Price website is not intended for investors in any jurisdiction in which distribution or purchase is not authorised, including the jurisdiction of the reader of this information, where applicable. For example, the information herein is not for distribution to and does not constitute an offer to sell or the solicitation of any offer to buy any securities in the United States of America to or for the benefit of United States persons. In certain jurisdictions, such as Australia, an investor must qualify as a wholesale client. Information contained in this website is not for retail investors. Information obtained from this site is intended specifically for the individuals who have agreed to these Terms and Conditions and may not be redistributed without prior consent from the T. Rowe Price Legal department.

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Persons who do not fall into the definition of wholesale client should not act upon the information contained herein.

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