By Manuel Arrive, Fitch France S.A.S., and Alastair Sewell, Fitch Ratings London
Fitch Ratings expects credit markets to be less directional in the coming months. As a result, short duration, lower volatility and absolute return strategies with more performance contribution from bond picking will gain traction and are currently being launched by most advanced asset managers.
Low growth and sustained net inflows (EUR228bn year to date to credit funds globally according to Lipper) have provided a supportive environment for the credit asset class over the past three years. Meanwhile, corporates continue to enjoy solid fundamentals, historically low defaults, lower leverage and ample access to liquidity.
However, at the current low levels of yield and high level of spread compression (‘A’ and ‘BBB’ European corporate spreads have reached 79 and 177bps respectively as at 19th October), Fitch expects to see credit asset managers preparing for a potential yield correction coupled with potential fund outflows.
Fitch expects bottom up name selection to be the main driver of performance in credit portfolios that will no longer be as dominated by systematic risk as they have been in the past few years. While default rates are not expected to rise significantly, higher spread dispersion is expected.
While institutional investors will continue to be attracted by the carry component of credit, performance oriented investors such as private banks and fund intermediaries will start looking for strategies capable of generating high single digit returns without excessive market beta risk.
Potential Redemptions an Issue on Lower Liquidity
Preparing for potential redemptions is starting to be a concern for the largest funds at a time when flexibility and ability to be nimble is crucial. Some credit funds, global and US high yield in particular, have faced significant inflows particularly from more volatile retail investors over the past 12 months. Furthermore, hedge funds can trade against the fund when it sells assets to meet large redemptions. On the asset side, liquidity has fallen in the credit markets over the past five years, as dealers are less active and the investor base is more fragmented.
Investors are looking for downside protection and credit returns that are less dependent on market direction, as they are seeing less potential for credit returns based on long-only strategies, at this point in the cycle. Strategies that can take relative value bets or hedge/manage market risk (both duration and spread risk) will be increasingly explored. Therefore, derivatives will be used more widely, specifically CDS, which provide liquidity and give the ability to short credits.
As many funds can accommodate these strategies, Fitch expects to see the following fund types being launched: short duration high yield funds, diversified (i.e. multi credit sub-asset class), low volatility or target volatility funds, as well as absolute return credit funds. Asset class and region focused, low tracking error, long only credit funds should be less popular than in the recent past.