In May, the spread of the ICE BofA High Yield Composite Index (Q964) widened by 24 basis points to a level of 303 basis points over the swap curve. This is equivalent to 347 basis points over the government bond curve. The index earned a total return of -0.83%. German 10-year government bond yields closed May at +1.12%, representing an increase of 18 basis points compared to the end of April 2022.

The month of May started out with an eerily calm feel, probably helped by national holidays in various countries throughout Europe. Spreads moved sideways for a few days and US equity markets were broadly flattish as well. This lack of volatility however didn’t last long. At the end of the week, spreads started to march higher and equity markets weakened considerably. There was no clear event that caused this weakness. A steady drumbeat of small negatives impacted risk sentiment. The continued supply of inflation figures that surprised to the upside, the impact of the very strict lockdowns in various parts of China, signs that inflation was negatively impacting economic growth around the world and the headlines surrounding the war in Ukraine all had its effects. Credit spreads topped out at almost 333 bps which was 30 bps wider than the highs reached in March.

In week three, the much hoped for equity ‘bear market rally’ started which calmed credit markets in Europe and caused credit spreads to contract by about 27 bps from the highs.

On the macro data front, the US ISM manufacturing index weakened to 55.4 from the 57.1 level reached in April while an increase was expected. The number does however point to still steady economic expansion in the US. This was also confirmed by solid durable goods and factory orders. Meanwhile, inflation numbers again came in higher than expected but declined slightly from the peak reached in April. CPI came in at 8.3% YoY vs 8.5 in April and expectations of 8.1%. Core CPI came in at 6.2% YoY vs 6.5% in April and expectations of 6%. The labour market remained very tight in the US and the unemployment rate remained at the 3.6% level. Despite this, real average hourly earnings remain in negative territory due to the aforementioned high inflation.

In Europe, labour markets continued to tighten. UK unemployment fell to the lowest level since 1974, while eurozone unemployment is now the lowest on record. This supported an acceleration in wage growth in both economies, but with inflation very high, real wages remain negative here as well.

The inflation numbers have kept all eyes on the path forward by central banks. US and European markets are now pricing an aggressive rate hike cycle for the next 12-18 months. This is on top of the quantitative tightening that is about to start with central banks unwinding their balance sheets after years of providing massive stimulus to the markets via QE. So far central banks have kept underestimating the strength and stickiness of inflation around the world and are trying to catch up. Especially in Europe the comments regarding rate hikes keep getting ‘nearer’ every month. From initial comments that this would be a 2023 event, to signaling that the policy rate might be increased at the end of the year but would be kept in negative territory, to ‘we might end the year at 0% rate’ to discussions about a 50 bps hike soon to combat inflation.

Anyhow, markets are now divided in two camps. One that rate hikes will cool the economy to such an extent that central banks are bound to stop their hiking campaign at a comfortable level for markets to continue to provide attractive returns to investors. The other one is that inflation is so sticky that central banks have no choice other than to continue to hike aggressively regardless of the impact this will have on economic growth and especially equity markets. As ever the hope camp is still where the majority of the investors currently reside. We lean more toward the latter camp. High inflation is worse for societies in the longer run than temporarily high unemployment numbers and we sense that on average central bankers around the world have internalized this. We also note that unemployment levels are at multi decade lows in major economies around the world.

We started the month moderately underweight risk from a beta perspective and kept this position relatively steady during the month.

During May the market finally opened up for HY issuers and we saw €2.0billion of issuance in European currencies and no issuance in Yankees (ex-financials, including FRNs). Fixed coupon issuance in European currencies amounted to €1.3billion. YTD issuance volumes are down 75% vs 2021. Refinancing needs are relatively limited in European HY which has provided issuers the luxury to wait and see.

The wider European HY market saw €1.4billion of outflow in May according to JP Morgan. This brings YTD outflow to almost €7billion which is in excess of 10% of the asset class according to JP Morgan (AUM in funds and ETFs).

The portfolio delivered a return of -0.83% (gross). This was exactly in line with the benchmark return of –0.83%. During the month, the portfolio’s sensitivity to market trends varied between 94% and 97% in beta terms. Our conservative positioning didn’t add much to our relative performance despite the spread widening. A number of specific hybrid positions we held underperformed the rally we saw in that space. This was compensated via solid issuer selection in the corporate and subordinated financials space. At a sector level, both our positioning in infrastructure and real estate contributed negatively while auto’s, insurance and telecom contributed positively.

In May, the Fund participated in new deals from Elis and in a LT2 from Erste Bank. New issue activity in the High Yield space remains very low for now. New Issue Premiums (NIPs) are quite attractive as a result but could become even more attractive when real issuance volumes return.

Outlook
Although credit spreads have widened quite a bit in May and are currently above the wides seen in March, we remain on the cautious side. We see more risks on the horizon, including a prolonged Russian invasion, uncertainty regarding European energy supply and security, weaker global growth, stubbornly high inflation and renewed Covid fears and associated lock downs in Asia. We are still moderately bearish and think spreads could move wider from here. The main reasons being, a weaker macro-economic environment, aggressive hiking by central banks and the start of QT globally. Q1 2022 company results were solid but we fear that higher rates and a potential recession in both Europe and the US over the next 18 months are not adequately reflected in earnings and profit guidance at present. Although spreads have backed up from all-time lows they are not yet high enough to fully compensate for the risks that we have identified. The technical situation does not help either with supply expected to increase from now on, with the ECB close to stop QE, issuers might want to use the opportunity to issue new deals before the summer period and after their Q1 earnings. For 2022, we expect spreads between rating categories to decompress. We are underweight the BB- segment as a result and have compensated this partly with an overweight position in IG rated subordinated paper. Lastly we are also underweight the longer end of the credit curve due to the expected impact of rising rates on longer dated maturities.