Credit Valuations This Week: RBS

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RBS strategists Edward B Marrinan, Edward Young, Gregory Kamford and Nicholas Kirschner consider whether credit market valuations in the week to November 8, 2013, are, in their words, overly ‘frothy’ or ‘bubbly.’

Risk appetite

“Reach for yield has manifested in a powerful rise in residential and commercial real estate values, a multi-year rally in equities that has seen the S&P 500 (INDEXSP:.INX) more than double from its post-crisis low in March 2009, and a remarkable renaissance in demand for both high and low quality corporate bonds, leveraged loans and structured products,”  say the RBS analysts.

Yet, they qualify that somewhat alarming statement, saying that valuations are still not ‘off-the-charts’ compared to long-term averages, and that “we believe most risky asset classes—corporate credit included—have some way to go before they reach levels that we would consider to be ‘frothy’ or ‘bubble-like’.”

RBS also soothes ‘taper’ fears saying its economists believe it will be an early 2014 event (the January or March FOMCs), and not later this year.

Credit valuations

An apprehension that there is an outside chance of the Fed commencing ‘taper’ this December itself has pressured the corporate credit rally in comparison to that in equities.

Yet there is a case for assessing the post-September rise in investment grade (IG) and high yield (HY) credits for rich valuation.

Here, the RBS strategists suggest evaluating corporate spreads as a percentage of yields. By this measure, RBS find that spreads are close to average historic levels but nowhere near all-time highs for either IG or HY.

credit valuation ig hy

“Furthermore, given that default and rating downgrade risks have remained close to record lows, it makes sense to us that spreads should be at the tight end of the current’s cycle’s range,” say RBS. This bolsters the argument that credit spreads are valued fairly.

In the aggregate, considering prevailing risk appetite, low default rates, better fundamentals and the postponed taper, spreads are likely to narrow.

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