Credit bear market has begun, Morgan Stanley warns
US corporate bond market has entered a bear market after hitting a peak in February, Morgan Stanley warned on Monday.
Analysts at the investment bank said 2017 proved to be the “Goldilocks” year for the credit market, as economic growth expectations brightened and investors looked forward to US tax cuts and a relatively accommodative Federal Reserve. But technical challenges began to appear in 2018 with the Fed “stepping harder on the brakes,” chasing more investors away from the US bond market.
Market fundamentals are expected to worsen next year. Morgan Stanley’s analysts noted that monetary policy has turned hawkish and should near “restrictive territory” for the first time in this cycle. Also, tailwinds from a booming US economy are beginning to dissipate while earnings growth slows, they said.
“We believe the credit bear market, which likely began when [investment grade] spreads hit cycle tights in February 2018, will continue in 2019,” strategists led by Adam Richmond wrote in a note to clients, adding that high-yield debt will probably underperform.
Morgan Stanley advised buying higher-quality bonds. It also said it prefers short-duration high-yield bonds and US over European banks.
Mr Richmond offered a silver lining for investors: the market is less complacent, and the recent sell-off has softened valuations in some corners. These two factors “help at the margin,” he said.
“While we certainly do not think the consensus has embraced the idea that end-of-cycle risks are rising notably, at the least, sentiment is much less uniformly bullish than it was at the beginning of 2018,” Mr Richmond wrote.
“That said, we very much stick to our bigger picture view that the credit bear market has started, and until valuations have truly priced in long-term fundamental risks, investors should use rallies to move up-in-quality.”