We believe however, that while the tug-of-war between compelling value and weak fundamentals will dominate markets in 2009, credit should ultimately benefit from the unprecedented policy response by governments and central banks.
Credit performance was dismal in 2008. Global investment grade and high yield corporate bonds underperformed government bonds by a staggering -16.5 per cent and -38.8 per cent respectively. Two themes prevailed: one, all risky asset performed poorly, and two, high quality assets, in most cases, underperformed low quality assets on a risk-adjusted basis.
The backdrop to this dislocation is a market cycle which it is now becoming almost clichéd to describe as “unprecedented”. A crisis which ensnared the global financial system, caused liquidity to dry up and markets to grind to a halt is not easily resolved. While the global economy remains in this dire state, corporate bond spreads will reflect this high risk environment.
Nonetheless, while this cycle is highly unusual in many respects, the basic boom/bust framework closely mirrors prior periods and thus we can begin to identify the events which may need to occur before risk levels decline and credit markets begin to rally.
Based partly on historical precedent and partly on the unique aspects of today’s environment, we believe several of the key factors necessary for economic recovery are actually already in place. These include: a coordinated monetary policy response; a globally synchronised policy response; extraordinary fiscal stimulus; stablisation of the money markets, and significant balance sheet reduction from levered investors.
While considerable progress has already been made, two elements remain unchecked. The first is the beginnings of economic stabilisation – which is certainly not in evidence currently. However, we do expect some signs of a turn in the economy in the second half of 2009 as a result of the aggressive policy responses. Secondly, we need an improvement in credit availability.
So do all the conditions need to be in place before we see an improvement in performance? Not necessarily; markets are anticipatory and in our view credit markets are likely to improve before all of the necessary elements for an economic recovery are fully in place.
We do not believe risk premiums will require actual growth to turn the corner, but simply moderation in the downward trajectory of real GDP. In addition, we anticipate that the unprecedented and aggressive policy response will give investor’s confidence that additional policy responses will be forthcoming should events worsen.
We believe that if evidence continues to emerge that policymakers are successfully repairing markets, credit spreads may be approaching a turning point. More importantly, credit risk premiums are so large, and yields are so high, at the moment that investors are ‘paid to wait’. Timing the bottom of the market is less critical when income levels are large enough to offset modest capital losses.
However, we should not underestimate the difficulty of predicting a turn in leading economic indicators. And while we believe current risk premiums over-compensate investors for default risk, the reality is that defaults are likely to rise sharply over 2009 while the macro picture remains so gloomy. A prudent, active approach to security selection will be critical to limiting default risk and maximizing return potential.
Our message for credit investors is a simple one. Prepare for negative news, prepare for volatility, but also prepare for solid returns from high-quality credit as markets normalise in coming years.
