Credit Suisse’s Investment Committee has been bearish on core government bonds – those issued by the U.S., U.K., Germany, Canada, and Switzerland – since February 5, 2015. The committee believed rich valuations left little room for further upside, and a pullback in both Bunds and Treasuries over the past two months hasn’t changed that view. What has changed recently, however, is the investment committee’s view on corporate bonds. In late May, the committee went underweight on investment-grade bonds and reduced its view on high-yield bonds to neutral.
The Federal Reserve is the driving force behind the bank’s less constructive outlook on investment-grade bonds. Credit Suisse expects the central bank to raise interest rates in September, a move that should drive up bond yields and drive down prices. The problem, at least for those with money invested in investment-grade bonds, is that the spread between the yields on investment-grade bonds and Treasuries is relatively thin – just 125 basis points as measured by the Credit Suisse Liquid US Corporate Bond Index.
When Treasury yields rise, investment-grade credit spreads tend to narrow – at least at first. While corporate bond prices do eventually follow those of Treasuries, a wide spread—through which corporate lenders are amply rewarded for their increased risk—can mitigate some of the interest rate risk to a portfolio as Treasury yields inch higher. But when spreads are already narrow going into a rate hike, there’s little incentive to stay in investment-grade bonds. “We already had investment-grade on a neutral weighting, as we still thought it would make sense to have investment-grade bonds in the portfolio to produce some income,” Credit Suisse Americas investment strategist Philipp Lisibach said in a recent interview. “But we now believe they may actually do harm to a portfolio.”
The change in outlook for high-yield bonds is an indication that the bank believes a rally that began at the end of 2014 has probably run its course for now. At the end of last year, panic had started to build about the dramatic decline in global oil prices, which had plunged to $56 a barrel from $114 in June 2014. Energy company bonds went into free fall, and passed their contagion on to the rest of high yield. While energy bonds comprise about 16 percent of the notional value of the high-yield bond market, the energy correction dragged the rest of high-yield down with it. Which also created an opportunity — a dramatic rise in yields that made the income from high-yield bonds worth the trouble. Between June 2014 and the end of the year, yields soared from 5.2 percent to 7.1 percent, as measured by the Credit Suisse US High Yield Index. “That was fairly attractive income, particularly in the current interest rate environment,” says Lisibach.
In the wake of the yield spike, the investment committee turned positive on high-yield debt in January 2015, anticipating that oil prices would begin to stabilize, and that high-yield debt would do the same. “Our total return expectation for this year was 5.5 percent,” says Lisibach. “In early June, we reassessed and found that high-yield year-to-date returns were 4.2 percent – so, much of our return expectations had already materialized, and we downgraded.” The energy sector has been responsible for much of that impressive year-to-date increase, with energy bonds returning 7.6 percent. But now, as Lisibach points out, investors have record-high levels of net-long positions in crude. “We would not be surprised if we saw some profit-taking, which would put pressure on the price of oil,” he says. “The energy rebound drove good returns this year, but it may now become a bit of a headwind.”
Finally, the investment committee sees trouble ahead in high-yield for technical reasons. Lisibach says the committee expects higher issuance in the next few months, as companies scramble to borrow before the Fed raises rates. But as post-crisis capital requirements have reduced the amount of assets financial institutions have available for trading, and thinner, more illiquid high-yield markets have been prone to bouts of extreme volatility. Lisibach expects the market to have trouble digesting the new issuance, putting further downward pressure on prices. And that is the anatomy of a downgrade: First, Credit Suisse’s return expectations for the year have already nearly been met; second, there’s likely higher volatility ahead. High yield’s recent run appears to be over.