Global investors face more years of a protracted low yield environment, as central banks slash interest rates to combat the coronavirus-led recession. The low yields have left many investors with insufficient returns to meet their goals, prompting some to look further out along the risk scale, often beyond their preferred risk tolerance. At PIMCO, we believe this is not necessary, as parts of some asset classes, such as credit, may still compensate for risk. Overall, however, we remain cautious on credit, given the economic slowdown and recent spread tightening, favoring high quality issuers. We highlight below where and why we see potential opportunities:

1) With a little help from the Fed

  • Using experience gained during the 2008 global financial crisis, major central banks have sought to rescue financial markets in periods of extreme volatility. From the European Central Bank’s (ECB) asset purchase program in June 2016 to the U.S. Federal Reserve’s (Fed) record-breaking measures announced in March 2020, central bank support has helped smooth markets, triggering a shift in investment flows. As shown in the chart, many investors are returning to investment grade and high yield credit markets.
  • This ongoing monetary support, combined with near-record-low government yields, may lead investors to seek income in traditional income-producing asset classes, such as credit.
  • This major central bank support does not mean, of course, that exposure to credit sectors cannot generate losses for investors, particularly in the short term. Amid the COVID recession, investors need to be vigilant of the risks, particularly at the lower end of the credit spectrum.

The chart shows that credit inflows increased following strong Fed support in April

2) Implied versus real defaults: an opportunity for active investors

  • Markets tend to exaggerate certain situations, turning unexpected events into panic or euphoria that eventually wane as fears and hypes calm down. At present, the uncertainty around the effects of the COVID-19 crisis on the global economy still weighs on credit, as much of the recovery depends on whether a vaccine will be ready, and when. This has made some investors price in a pessimistic scenario, which might actually be far worse than what time brings.
  • As seen in the chart, current spread levels imply that more than 12% of the outstanding U.S. investment grade companies will default (fail to meet payments) over the next five years. This is much worse than the worst historical five-year cumulative default rate of 2% for the asset class. In other words: Things have never been as bad as what the market is implying. Europe offers a similar scenario.
  • Active investors who can focus on the highest-quality and most resilient companies may benefit from any spread tightening that may happen if real default rates are lower than what markets expect.
  • Assuming a 40% recovery rate, current investment grade credit spreads imply default rates of more than 10% in both Europe and the U.S.
  • This far exceeds the worst actual 5-year cumulative default rates experienced in investment grade corporate credit.

The chart shows that the implied default rate in investment grade is far higher than the worst-of-times real default case