With favourable conditions for credit having driven spreads in some sectors close to all-time tights heading into 2025, some market participants have begun to speak of late-cycle exuberance and a potential correction.
Below, we look at the factors that have supported credit in 2024 and which, if any, of those factors we think could change in the coming months.
Unsurprisingly, of the sectors we track it is the higher beta markets of collateralised loan obligations (CLOs) and bank Additional Tier 1 bonds (AT1s) that have led the way in 2024, posting double-digit returns year-to-date (see Exhibit 1). Investment grade (IG) non-financial GBP bonds have been a relative underperformer, returning just under 3% YTD, though this is primarily driven by the underperformance of Gilts against both US Treasuries (USTs) and Bunds.
This isn’t far removed from what many expected from credit at the start of the year, given high all-in yields meant the income generated from coupons and pull-to-par alone offered solid-looking return prospects (not unlike the outlook for 2025).
However, 2024’s returns have been aided by spread tightening, which is why many are now questioning whether credit can repeat the trick in 2025. Besides a relatively benign macro environment, healthy corporate fundamentals and a strong technical bid for corporate debt have driven credit performance in 2024 – so in our view the key question is whether these two factors will weaken over the next 12 months.
Looking at corporate fundamentals, some businesses have no doubt suffered from rate rises but most have navigated the environment well, and solid earnings growth has generally supported credit metrics.
Net leverage in the high yield (HY) space, for example, is towards the bottom end of the 10-year range, and below where it was in Q4 2019 (see Exhibit 2). Interest coverage, while inevitably declining from the peaks of 2022, remains around its longer term average.
In the IG space, net leverage is roughly in line with the five-year pre-Covid average, although interest coverage has fallen quickly from the highs of 2022 to settle slightly below the longer term average.
Profit margins in both IG and HY have been resilient, though it is fair to say there has been dispersion among sectors and ratings. Low margin, commoditised sectors such as industrial chemicals have seen pressure, for example, while higher rated businesses and those with significant pricing power have in some cases expanded margins materially.
HY default rates, while higher than the longer term average in Europe, remain subdued at below 3%. US default rates are even lower at just over 1%, well below the longer term average of 3.5%. Distressed ratios – the percentage of the index trading above 1,000 basis points (bp) in spread – are 7% and 4% below their post-crisis averages in the US and Europe index respectively. Defaults on a forward-looking basis should also be relatively subdued given the number of HY firms that have successfully termed out a large percentage of short term debt.
We see similar fundamental strength in financials, where higher interest rates have been a profitability tailwind for European banks in particular; the sector’s forecast 11.5% average return on equity for full-year 2024 is a world away from the 4-6% average seen during the negative rate era. Combined with impressive capital levels and the significant post-crisis improvement in loan book quality (average non-performing loans are around 2% now versus 8% 10 years ago), this has helped Western European financials to achieve the highest upgrade/downgrade ratio of any credit market over the past two years.
When it comes to the technical bid for corporate debt (i.e. a favourable balance of demand versus supply), one way to measure this is to compare fixed income fund flows to net bond issuance.
On the flow side, 2024 has seen a record year for inflows into European credit. While spreads are relatively tight, overall yields remain attractive and well above 10 and 20 year averages (IG bonds now offer yields that in 2021 could be achieved on CCC rated credits, for example). This underpins the cross-asset relative value of credit in our view, particularly compared to the dividend yields that look achievable in equities currently. Leaving aside cross-asset flows, the coupon payments bondholders are due to receive next year will in some cases be larger than the expectation for net supply.
Gross supply across IG and HY markets increased in 2024 and is on course for a record year in US and European IG. The most important driver of the technical however is net supply, i.e. the amount of new bonds issued versus those maturing. Whilst elevated in IG, net supply has been much lower in US HY and negative in European HY, both as a result of limited organic issuance and a net migration of bonds being upgraded to IG. We expect HY net supply to pick up in 2025 but to remain below longer term averages.
In financials we expect a similar story, with net supply from European banks expected to be close to zero across most of the capital structure, including senior, Tier 2 and AT1 bonds. This longer term technical tailwind (banks only have a set amount of capital as a percentage of assets they need to issue) should continue to support spreads in the sector.
When it comes to valuations, fixed income investors will be looking at today’s tight spreads in the context of still-high overall yields.
There would appear to be a tension between these two facts, but it makes sense given the macro environment; central banks hiked rates aggressively but are cutting more gradually (hence yields remain high), yet growth still remains robust and consumer and corporate balance sheets look solid (hence tight spreads).
Euro HY and IG spreads are around 80bp and 20bp tighter than their 10-year averages respectively, but in yield terms they are 100bp and 140bp higher than their 10-year averages.
While the picture is similar in the US, valuations do appear more stretched; HY and IG spreads are around 160bp and 45bp inside their 10-year averages, respectively, though again in yield terms they are 35bp and 140bp above their 10-year averages.
Ultimately, we don’t expect to see a sustained credit spread widening in 2025 as long as the fundamental and technical tailwinds remain in place, which they seem likely to do.
To be clear, with considerable uncertainty surrounding the trade policy of the incoming US administration and a troubling geopolitical backdrop, there are numerous potential catalysts for volatility and spreads could certainly spend periods of 2025 wider than they are now. However, we don’t expect to see a level of weakness that could be termed a “correction” in credit.
High yields offer fixed income investors some downside mitigation against spread volatility, and central banks have “dry powder” to increase the pace of rate cuts if the macro environment weakens. As a result, we think credit spread widening will most likely provide opportunities for the active investor.
Important Information: The views expressed represent the opinions of TwentyFour as at 11 December 2024, they may change, and may also not be shared by other members of the Vontobel Group. The analysis is based on publicly available information as of the date above and is for informational purposes only and should not be construed as investment advice or a personal recommendation.
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