In the current environment, we believe investment grade credit could be well suited for investors grappling with a variety of potential market scenarios in the coming months.
We see four main reasons to like the asset class: support from central banks, yield pick-up versus government bonds, tight spreads and potential for gains following vaccine roll-outs.
The Current Landscape for Investment Grade Credit
Investment grade (IG) credit has enjoyed strong gains since the US election, with spreads to government bonds compressing to levels close to those seen before the pandemic. Indeed, spread narrowing has been so sharp that some see the move as over-done. After all, there is little certainty around how quickly the vaccine roll-outs can occur and people can return to work. What the post-pandemic world looks like is also unclear, with the long-term damage to the economy an unknown.
Perceptions that markets have priced in a lot of good news is not confined to IG. In fact, the asset class is in good company as many equity indices have hit fresh all-time highs and high yield credit spreads are also back at levels last seen in early 2020.
Conversely, for many who view their investment horizon through the lens of an economic rebound, it is easier to argue that government bonds, and not risk assets, look expensive. While US Treasury yields have edged a little higher, central bank buying is restraining the impetus for yields to rise to a meaningful degree. Some investors may retain a preference for safe assets past year-end but the drag of negative or, at best, low yields is a challenge for investors.
In addition, just because central banks remain committed buyers, there is no guarantee of perpetually low yields. Figure 1 below illustrates the inconsistent relationship between ECB government bond purchases and the 10-year bund yield. Yield spikes have occurred on numerous occasions despite a heavy program of buying. While the ECB’s additional EUR 500 billion of purchases and the extension to the program will be welcomed by the market, issuance in 2021 will remain high and will be added to by the EU’s pandemic recovery fund, which aims to raise EUR 750 billion.
Figure 1: ECB Government Bond Purchases vs. the 10-Year Bund