Skeptics including Aegon Asset Management and Barclays Plc are preparing for the possibility that April’s credit rally could evaporate as swiftly as it materialized. The robust performance of credit markets in April, which saw global investment-grade credit log its best month since August and high-yield its best since 2023, returning 1.3% and 2.3% respectively, may be short-lived.
This optimism, fueled by investor bets that the conflict in the Middle East is waning and strong US earnings, has created what Barclays strategists have termed a “don’t worry, be happy” market. However, recent developments, including crude oil prices hitting a four-year high and a sharp climb in Treasury yields driven by inflation concerns, are casting a shadow over this sentiment.
Persistent Risks Undermine Rally
Despite the positive market movements, few of the underlying risks that prompted caution in March have been fully resolved. The Strait of Hormuz, a critical chokepoint for global oil and other trade, remains effectively closed, a situation that has direct implications for inflation and transportation costs. The US and Israel’s strikes against Iran in late February and Tehran’s subsequent threats to attack ships in the strait have led to a near standstill in traffic through this vital waterway.
Alex Pelteshki, a portfolio manager at Aegon Asset Management, expressed concern over the ongoing situation. “We think spreads will sell off but we don’t know when,” Pelteshki stated. His firm is adopting a defensive posture by focusing on collecting yield in shorter-dated bonds. “It doesn’t seem like there will be material flow of things flowing through that strait. Not just oil, but also fertilizers, what have you,” he added, highlighting the broad economic impact of the blockade.
Investor Strategies for Protection
In light of these persistent risks, some investors and strategists are recommending protective measures. These include buying credit default swaps (CDS) on the market or opting for shorter-term debt to hedge against a potential downturn. Hedging costs have recently become more attractive. The five-year CDX North American Investment Grade index was trading around 54 basis points on Friday, a decrease from approximately 68 basis points in late March. This means hedging $10 million of principal would now cost around $54,000 annually, down from previous levels.
Following the outbreak of conflict in Iran, investors had increased their protective hedges and briefly adopted short-risk positioning in the iTraxx Main index, according to Barclays. Some of these investors are maintaining their hedges. Felipe Villarroel, a portfolio manager at Twentyfour Asset Management, is adopting a cautious approach. “We’re kind of waiting and seeing what’s going to happen, if the war restarts or if the Strait remains closed,” Villarroel said. He had increased his hedges using the iTraxx Crossover credit-default swap index at the beginning of March and continues to hold a portion of that position.
Shifting Market Sentiment
By late March, market sentiment had begun to reverse, driven by the belief that the worst of the Middle East conflict had passed. This shift led to positioning that was long relative to historical norms, according to Barclays. However, the recent escalation in oil prices and rising Treasury yields suggest that this optimistic outlook may be premature. Central banks, which were previously expected to lower interest rates this year, now find themselves in a state of uncertainty as they monitor inflation for signs of resurgence. The ongoing geopolitical tensions and their impact on energy markets and supply chains continue to pose a significant threat to the stability of credit markets.
The current market environment presents a dichotomy: a strong recent rally juxtaposed with fundamental risks that remain unresolved. Investors are thus faced with the challenge of balancing potential gains with the need for robust risk management, as the prospect of renewed market volatility looms.
