During the third quarter, investors saw volatility driven by China risk, supply chain issues, and inflation pressures from energy and wage inflation. Performance of the various asset classes across the credit and arbitrage landscape varied depending on factors such as rate exposure, seniority, and supply pipeline, which are juxtaposed against broadly positive fundamentals.
In corporate credit, U.S. high yield saw 15 basis points of spread widening versus 3 basis points of widening in European leveraged finance. The markets ended September at 385 basis points and 355 basis points, respectively. Defaults continue to fall, with the U.S. posting the lowest quarterly volume since 2013 and Europe witnessing no defaults. As of September 30th, the high yield default rates in the U.S. and Europe stood at 0.99% and 1.5%, respectively. Elevated issuance continued in the U.S., with five of the seven largest quarterly new issue volumes in U.S. high yield occurring since the second quarter of last year. Meanwhile, European high yield saw a drop in third quarter issuance after a record-setting second quarter.
In residential and consumer debt, favorable collateral fundamentals, record-high home prices, demand for yield, and continued employment gains kept spreads firm. CRT spreads tightened by 10-20 basis points, while non-QM and legacy asset spreads changed little. In consumer ABS, the AAA tranche saw spread widening, while the subordinate tranches saw spread tightening, as bids remained strong. In commercial real estate debt, despite late summer doldrums and concerns surrounding the Delta variant, conduit and SA/SB new issuances saw record volume during the quarter, with the percentage of loans going to a special servicer continuing to decline.
Convertible bond issuance took a breather, as a sense of caution permeated the equity market late in the quarter and valuations were softer, and the HFRX Relative Value Fixed Income Convertible Arbitrage Index gave back a small amount of the gains from earlier in the year. Meanwhile, SPAC issuance picked up from the prior quarter. Together, SPACs that have yet to announce a combination and those that have announced a combination but not yet closed represent a total of $34.8 billion of capital and $318 billion of enterprise value—an opportunity that provides downside protection via trust value with upside optionality.
In merger arbitrage, the Department of Justice’s lawsuit against Aon plc and Willis Towers Watson created widespread deleveraging; however, arbitrage spreads stabilized as M&A announcements continued to surge against the backdrop of higher regulatory uncertainty from the DOJ, FTC, and the White House. Investors in the space can add alpha via a highly selective approach to merger transactions.
Turning to real estate, the global economic recovery has continued to drive improved fundamentals in the commercial real estate market. Broadly speaking, transaction activity and pricing have now returned to pre-pandemic levels across most geographies. Further the relative value of real estate as compared to corporate bonds continues to drive more capital to the space. However, the bifurcation of the ‘have’ and ‘have not’ sectors that has been persistent since the onset of the pandemic has become even more pronounced. A record amount of capital is being deployed in the more favored sectors, such as multifamily and industrial, which has driven yields to all-time lows. Out-of-favor sectors—like gateway office, retail, and certain segments of hospitality—continue to lag in their recovery, as the rise of the Delta variant has slowed down and spurred questions about the prospect of a return to ‘normal’ usage of those property types across the globe. Niche asset classes—such as life sciences, medical office buildings, self-storage, and data centers—have benefited from real estate investors that have sought to deploy capital in growth-oriented property types and away from out-of-favor sectors.
In the U.S., the economy continues to demonstrate a significant recovery from the depths of the pandemic. Transaction volumes were up 151% year-over-year and are now on pace for the highest yearly volumes on record. From a geographic perspective, transaction activity has been significantly more robust in growth markets, such as Atlanta and Dallas, while investors have been slow to return to gateway markets. With regard to valuations, the Green Street Commercial Property Price Index increased 18% year-to-date and is now 8% higher than pre-pandemic levels.
In Europe, GDP recovery has been strong across most of the region. Unemployment levels in Europe have been buoyed by government-funded furlough programs, which are set to expire in the coming months and will test employment levels across the region. Real estate activity has continued to be somewhat stagnant across the region, with investors most focused on multifamily and industrial assets. Leasing activity has increased substantially in office, with many tenants focused on identifying high-quality space that will provide employees with attractive amenities and flexible arrangements upon a full-time return to the office.
Economic growth across Asia—which had slowed earlier this year due to a lag in vaccination rollouts—is now back on track to be robust through 2021, as the region has been able to aggressively inoculate its population over the last several months. Real estate transaction volumes have generally recovered to pre-pandemic levels, and fundamentals are particularly strong in office and logistics assets across the region.