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Our views 06 December 2021

JP’s Journal: November credit and gilt divergence

5 min read

November proved to be a tricky month for credit markets. The cause was concern about Covid mutations and the potential impact on economic activity. If we look at the sterling investment grade credit market there are several striking features over the month.

First, there was a marked differential in performance of credit and gilts. This mainly reflected the longer duration of government bonds; but even normalising for this, credit lagged with spreads moving out by 9bps. This may not sound much, but it has taken overall credit spreads back to January levels. Yes, credit has outperformed but this just reflects the higher initial yield.

Second, some of the best performing sectors this year went into reverse and gave markedly negative returns. This was most noticeable in the insurance and banking sectors and, in particular, those bonds lower in the capital structure (i.e., riskier debt). Issuance in subordinated financial debt has been relatively strong this year and investors have generally benefitted from a new issue yield premium and the move lower in spreads. A combination of some new issue indigestion and greater risk aversion led to bank and insurance sectors seeing credit spreads widen by 16bps and 19bps respectively.

I continue to like both of these areas but it shows the importance of sector diversification in credit. An observation I sometimes hear is that RLAM’s sterling credit portfolios are too diversified. Naturally, I disagree; our strategies have high active risk – that is, we diverge from index composition. We want to spread this active risk over multiple opportunities. What we will not do is run portfolios with high ‘economic’ concentrations.

Third, we saw some spread weakness at the short end of the market – an area which has generally been very well bid through most of the year. This reflected a re-appraisal of the outlook for short-term interest rates – a process that accelerated in November despite the Bank of England (BoE) holding Bank Rate at 0.1%. While our enhanced cash and short duration credit portfolios have been impacted by this move, I think they look well placed against longer-dated strategies. I am really struggling to find value in long-dated gilts at present levels. To see short-dated yields above long yields is not unusual; what is amazing is to see five-year yields go above 50-year yields when the Bank Rate is virtually nil. To see the BoE buying long-dated gilts in the market at yields well below 1% is truly mind boggling. I see no economic case.

Cash and government bonds

Inflation continued to grab headlines. In the euro area, CPI surprised on the upside, jumping to nearly 5%. A large chunk of this increase relates to energy prices, just as in the UK, but the core rate was also high. In the US the Federal Reserve set a hawkish tone with Chairman Powell retiring the word “transitory” in relation to inflation. While acknowledging that Omicron posed downside risks the emphasis was on present economy activity being robust and strong inflationary pressures. Bottom line: tapering is being brought forward by the Fed. Where was the taper tantrum? Well, it got lost in the market turmoil and rising risk aversion. What we saw was significant yield curve flattening as short rates adjusted to the prospect of rate raises also being brought forward.

US employment data did not clarify much. The non-farm payrolls number was a significant disappointment rising only 201K. However, the unemployment rate fell quite a bit more than expected, to 4.2% from 4.6% despite signs that the participation rate is increasing a bit.

In the UK 10-year yields ended the week at 0.75% while 50-year bonds closed below 0.6%. In the US investors focused on the weaker aspects of the payrolls and pushed 10-year yields below 1.4%, the lowest level in Q4 whilst 30-year yields moved back to the January levels of 1.7%. German 10-year yields pushed towards -0.4% while the French equivalent went negative.

Real yields continued to hit new lows across markets – it remains the most important financial number.


In November high yield markets were weak – not surprising given the risk aversion trend. However, the moves we saw were quite significant with index spreads 50bps wider. There has been a small recovery in recent days and overall, I am pretty constructive on high yield markets at present levels. The moves look overdone, as defaults remain low and spread compensation is healthy for the outlook we see. In emerging credit China was not the centre of attention last week. We saw weakness in Ukraine and Turkey credits which helped drive EM spreads even wider. Our strategies are not presently exposed to Turkey but the size of moves may throw up opportunities, especially for exporters.

Investment grade credit drifted a bit wider and valuations remain attractive i.e., compensation for default risk remains above required levels in my opinion. Liquidity in sterling markets took a lurch lower during the risk off phase and is a good reminder that credit investments are not cash proxies. Last week it was difficult to get reasonable bids on several of big and supposedly liquid issues. Admittedly, weakness in the financial sectors made these areas tricky but we should not expect a material improvement as we go into the Christmas period. Conversely, there continues to be ongoing demand for asset backed and secured debt.


Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.