After narrowing rapidly in early 2019, we expect spreads – the difference in yields between sovereign and corporate bonds – to remain broadly flat for the rest of the year thanks to low expected default rates in the US and Europe, stable issuance, and decent earnings growth. However, spreads could begin to widen slightly by early 2020 as investors start to factor in the risk of a US recession in 2021 which could trigger the next wave of defaults.
Still prefer High Yield to Investment Grade bonds
Stable spreads ahead After narrowing by 150bp in early 2019, we now expect US HY spreads to stabilize in coming months, especially as default rates are well below historical averages. We do not expect spreads to widen again until early 2020 when the postponed rate hike could tighten financial conditions.
HY in Eurozone still offers attractive carry Eurozone HY spreads have tracked US spreads lower since early 2019. Bank lending to non-financial corporates has gained traction and there is no sign of any tightening in financial conditions. Like in the US, default rates remain low and well below historical averages. Appetite for yield will encourage investors to prefer corporate bonds to sovereigns. We prefer HY to IG given the attractive carry. Tight IG spreads offer little shelter from any rise in sovereign yields.
Time to be constructive on UK corporate bonds
UK High Yield benefits from a large protection In the UK, HY spreads have narrowed by only 80bp – half as much as in the US and EMU – because of lingering Brexit uncertainty. Our core scenario is for “soft” Brexit and so we would expect spreads to tighten further. In addition, the carry on UK HY is very attractive – spreads would have to widen by more than 275bp before generating a negative return. Nonetheless, risks abound – a chaotic Brexit remains possible – particularly for smaller domestically-focused issuers.
Issuance will be of little concern in the short term On the corporate bond market, peak refinancing needs remain well in the future. In the US, refinancing of maturing IG bonds will peak in 2021 at $500bn while the top for HY will not come until 2025 at $200bn. In Europe, IG refinancing will peak in 2022 at €250bn while the high point will come in 2023 for HY at €50bn. This means leveraged companies should have no difficulty rolling over their debt for now, especially with low interest rates and no signs of recession.
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