Credit Continuum – February 2018

Risk assets have had a bumpy start to the year. Rates pressures have continued to increase, weighing notably on the investment grade credit segment of the market, and this volatility has picked up steam into February, leading to a sharp correction in equity markets.

In our view, the recent sharp correction is likely to be a result of a number of factors that had not previously been widely considered by market participants – namely the long-term impact of the US tax reforms and the recent move higher in inflation expectations.

As a result, bond yields have adjusted swiftly since the beginning of the year to the point they have placed equity market valuations at very expensive levels, despite the high quality of Q4 2017 corporate earnings results. In parallel, equity volatility has risen as the equity market fell and this has created potentially significant losses through some short volatility ETF products.

In our view the rise in yields is not a surprise. It is important however to reiterate that economic fundamentals remain strong, which in turn is having a positive impact on corporate fundamentals. Last quarter’s earnings were very encouraging and we continue to expect a low default rate for 2018.

We maintain a preference for credit risk to interest rates. We also like the protection that high coupons offer in a rising yield environment – high yield assets generally offer more resilience to rising rates than investment grade credit; duration has extended significantly in the latter over the past two to three years. High yield bonds tend to be less volatile than US Treasuries and/or equities. We also continue to believe loans appear attractive; the floating rate nature of these instruments provides protection against rises in base rates and their performance also tends to be less volatile due to their primarily institutional investor base.

We have stressed for some time that valuations were tight, particularly in equity markets, while the low default rate continues to highlight strong fundamentals in credit. Our focus on quality continues to be an important factor in mitigating risk and providing downside protection during times of high volatility.

Overall we continue to retain our constructive stance on credit.

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Important Information

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