(Bloomberg) -- Concerns about a second wave of virus infections and its economic impact are key factors expected to drive volatility in credit markets for the next six to 12 months, said Christopher Sheldon, co-head of leveraged credit at private equity firm KKR & Co. High-yield bonds remain attractive.
Markets rebounded from March lows due to the Federal Reserve’s intervention rather than a broader economic recovery, resulting in a “tremendous rally across equity and credit instruments, while straddling a fragile market backdrop,” Sheldon wrote in a quarterly leveraged credit report released on Thursday titled, “The Twilight Zone.”
“The market snapped back so quickly but nothing has really changed from April,” Sheldon said in an interview this week. “We are now seeing a spike in cases and a second wave. We aren’t in a much different place than in April but the market is in a different place because of the Fed.”
That will lead to a burst of volatility, though the market won’t return to March lows in the near term, Sheldon said. The high-yield bond and leveraged loan markets dropped nearly 20% in about a three week span in March, according to the Bloomberg Barclays high-yield bond index and the S&P/LSTA leveraged loan index.
“It won’t be as broad as in March but more idiosyncratic. The haves and the have nots. When the haves fall, it’s going to drop a lot. And when a have not becomes a have, it will increase on thin air.”
KKR has deployed $18 billion across all strategies since February and about $7 billion in credit markets, said Sheldon, who doesn’t expect to invest at the same pace into the public credit markets in the second half of the year. He does expect to increase money allocated to private credit markets.
Opportunities will be more specific going forward, with a preference for credits with strong fundamentals and healthy balance sheets, according to the report. As for particular sectors, Sheldon sees appealing investments even in companies heavily impacted by Covid-19.
“There’s still really interesting businesses in Covid-impacted sectors,” he said.
High-yield bonds are still attractive on a spread and relative basis in the near term, though KKR expects investing in the asset class will get more difficult in the future, according to the report. The preponderance of fallen angels, investment-grade bonds that get downgraded to junk status, is extending duration in the market. Longer duration should outperform short duration bonds, but there’s potential for an increase in gap risk.
Another potential catalyst for volatility is the Federal Reserve and when it ends its extraordinary market intervention. The Fed this week said it has extended its emergency lending programs until the end of the year.
“ETFs are surging and I worry about the market technicals when and if the Fed pulls out or messages that they will begin to pull out,” Sheldon said. “The market is still fragile and there could be material mark-to-market volatility when that happens.”
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