- Credit markets rallied on expectations of less severe tightening. EUR IG +1.61%, EUR HY +2.49%
- IG and European ETFs preferred by investors, $ 21.14bln inflows into USD Investment Grade, +4.7% new investor capital in January for EUR IG
- 85% of US IG yield movement in January was driven by the sovereign curve
- ETFs and OTC instruments credit risk measures converge, basis for US HY contracts -26bps
Corporate Credit markets started the year with good gains, reversing some of the losses incurred in the second half of December following the central bank meetings on 14 and 15 December. Central Bankers in Europe and the US had specifically cited financial conditions as counterproductive to tightening efforts and reiterated earlier comments that market expectations for terminal rates were mispriced. With the turn of the year, market participants started to focus on the reopening in China, cooling inflation data and a potential for a soft landing, triggering a rally across risk assets.
Risk capital has started to enter credit markets. Credit ETFs see significant fund flows, with most flow moving into less risky tranches and US ETFs exhibiting the highest market penetration. In the US, investment grade focused funds saw $21bln of new investments, while high yield focused funds saw inflows of around $1bln, slightly less than the 1% of the total market cap ($118bln) of all US high yield ETFs on Jan 31st. ETFs on European Investment Grade bonds saw a net inflow of €2.9bln between Jan 1st and Jan 30th, an addition of 4.7% of the total market cap on Jan 31st. European high yield ETFs, still a nascent market, saw inflows of €276mln, contributing 3.5% to a total of €7.86bln.
The Bloomberg Euro Aggregate Corporate Total Return Index (EUR IG), tracking Euro Investment Grade credit, rose +1.61% between Dec 30th and Jan 31st, while European high yield credit, aggregated in the Bloomberg Liquidity Screened Euro High Yield Bond Index (EUR HY), has been able to overcome the initial slump in the second half of December, where it had lost -1.19%. In the period between Dec 30th to Jan 31st, the EUR HY Index was up + 2.49%.
USD-denominated credit markets have experienced higher volatility than their European counterparts. The main iShares UCITS ETFs on USD Investment grade (IG) and High Yield (HYG) Credit had lost -3.91% and -2.71% in the second half of December 2022, respectively. Those losses were regained in the beginning of January when IG rallied +4.81% and HYG +3.67% between Dec 30th and Jan 31st. USD-denominated sovereign credit, i.e., USD-Sovereign Debt from outside the US, as captured in the J.P. Morgan EMBI Global Core Index (USD EM), exhibited a similar pattern, falling -1.99% between Dec 14th and Dec 30th, before rebounding +3.29% by Jan 31st.
Credit spreads continued to tighten, contributing to the rally in global markets. In Europe, spreads trended lower ever since their last spikes in October 2022. EUR HY spreads to the interpolated sovereign yield curve fell -55bps between Dec 30th and Jan 31st, back to 433bps, a level last seen in April 2022. This marks a -224bps decline in the credit risk gauge since Oct 13th, the most recent peak. Similarly, EUR IG had credit spreads tighten by -11bps between Dec 30th and Jan 31st, to 152bps.
Duration, rather than credit spreads, has driven profit and loss in IG credit markets in the EU and US. Yield movements do impact IG bonds more than HY or EM. Higher quality tranches are generally issued with a higher maturity and lower coupons, leading to higher duration and sensitivity to movements in the benchmark. For EUR IG, the benchmark yield increased +61bps in the second half of December before falling -21bps up until Jan 31st, while in the US, the IG benchmark rate first increased +81bps and fell -56bps again for a net +25bps between Dec 14th and Jan 31st. For EUR IG, benchmark movements comprised 58% of the total yield move in January, while 85% of US IG yield movements were driven by the Treasury curve.
High yield markets have been influenced by benchmarks as well. However, credit spreads continue to drive the segment. EUR HY had the benchmark rising +57bps in the second half of December before falling -21bps in January. In the US, the HY benchmark fell throughout the period, first -15bps in the second half of December and then another -18bps in Jan.
As of Feb 7th, OTC credit default swap markets continue to perceive Europe as riskier than the US. As captured in the iTraxx Europe Index, Default probabilities for European IG are at 6% vs. 5.6% for its US counterpart. For high yield, the iTraxx Crossover prices in an average 28% default probability over the next five years, while the US equivalent is at 25.8%. This translates to a 30bps-50bps difference in default probabilities per year. Note that the differential in default probabilities is reflected in the respective credit spreads, whereby EUR HY yields around 80bps more than US HY for a similar duration.
Credit risk measures in European credit markets have continued to align more between OTC derivatives and credit ETFs. The CDS-spread vs. I-spread basis of IEAC, i.e., the difference between the funds' average interpolated spread to the swap curve and corresponding credit default swap index spread, continues to be negative but has been trending towards neutral. Similar observations can be made for the iShares EUR High Yield Corp Bond UCITS ETF (IHYG) and LQDE. For US high yield, the IHYU ETF exhibited a positive basis throughout 2022, which has contracted throughout Q4 2022. This trend continued into January, with the basis falling -26bps between Dec 30th and Jan 31st.
Utilizing Eurex's Credit Futures & Options for Market Positioning
Eurex Credit Futures and Options enable you to hedge existing portfolios against duration and credit risk in one go. Eurex Options on Fixed Income ETFs allow for directional positioning while limiting options premium paid with options spreads or more tailored option strategies.
Market neutral credit spread trades between EUR IG and HY are now also possible at Eurex with our Bloomberg MSCI Euro Corporate SRI Index Futures (LXYA index) and Bloomberg Liquidity Screened Euro High Yield Bond Index Futures (AHWA Index).
Be it to position for a rally in credit markets or in search of alpha in a specific sector, our market makers are ready to show you prices at competitive spreads both in the order book and in broker-facilitated phone market trading. Reach out to the team for more insights and execution guidance.
