Rationality will win out for AT1s in the real world
Bond market volatility remains elevated as persistently high inflation, compounded by the Russian invasion of Ukraine, has driven central banks to adopt a more hawkish monetary policy stance. However, in recent weeks credit spreads have started to cushion some of the underlying rates moves.
The hawkish rhetoric continues to drive government bonds wider, with 10-year Treasury yields currently trading at approximately 2.80% relative to 1.50% at the beginning of this year. Given the limited spread buffers available in investment grade markets and longer duration, Q1 represented the weakest quarter on record for US investment-grade, surpassing the sell-off during 3Q 2008. With the weakness observed in Q1 extending into April, US investment-grade returns year to date reflect declines of almost -10%.
As we have argued before, shorter-dated products with spread can offer strong breakeven protection in a volatile environment. As a result, high yield assets have significantly outperformed investment grade bonds, particularly in the sterling and dollar markets, where rates moves have been most aggressive. Consequently, the US high yield index has outperformed the US investment grade index by 383bp so far this year. Similarly, sterling high yield assets have outperformed the sterling investment-grade peer group by 450bp.
Interestingly, whilst rates curves have continued to rise in recent weeks, high yield spreads have cushioned much of this move. US high yield spreads, for example, are 60bp tighter than they were during March's peak. Likewise, European high yield spreads have tightened by 87bp since the highs experienced on the 8th of March.
We believe two factors have primarily driven this spread tightening.
Firstly, the technical backdrop remains strong. High yield markets in Europe and the US have experienced very low issuance levels this year, and investor cash balances have remained well above their historical averages, leaving investment bank trading desks relatively short of inventory. As flows have turned more positive (as they have done in recent weeks), offer side liquidity has remained thin, and bond prices have been marked up.
Secondly, credit markets are robust, and default rate estimates remain low, despite a weaker growth environment. Given the combination of both factors, the spread tightening observed in high yield markets makes sense.
That said, uncertainty persists, and the possibility of a further escalation in sanctions remains elevated. As a result, while we do not view current spread levels as expensive, we do not regard them as cheap. Therefore, in recent months, we have focussed our efforts on trading up in quality, positioning at the short end of credit curves and buying those names we believe possess strong pricing power, enabling them to perform in an inflationary environment.