The search for yield continued in the second quarter, as strong technical factors were supported by improving fundamentals, and new records were set for issuance volume and fundamental metrics. Despite brief periods of volatility due to inflation concerns, most credit instruments posted positive quarterly performance.
In the second quarter, the risk-on theme continued in corporate credit, with U.S. and European high yield markets returning 2.8% and 1.6%, respectively. Lower-rated credits strongly outperformed higher-rated credits, with the energy sector posting the strongest second quarter performance. The first half of 2021 also saw the lowest default volume in a decade, with the trailing 12-month default rate as of the end of June falling sharply, as the second quarter of 2020—a high default period—fell out of the measurement window. Despite outflows from U.S. high yield funds, the primary market remained open, with four out of the five highest quarterly issuance levels occurring in the last 12 months.
In residential and consumer debt, continued home price appreciation, improved employment, and strong technicals drove spreads tighter; most ABS asset classes ended the second quarter with spreads below their pre-pandemic tights, with aircraft ABS being the notable exception. In commercial real estate debt, the senior bonds of conduits saw multi-year tights on both a yield and spread basis, with sectors that were hit hardest by the pandemic—hotels and retail—leading the recovery.
Strong convertible bond issuance continued in the second quarter, bringing first half volume to an all-time high. The U.S. SPAC market saw slower primary activity, though this was balanced with increased back-end deal announcements and closings. In Europe, the nascent SPAC market continued to gain traction. Going forward, we expect diverging views on inflation, the Fed’s potentially hawkish shift, and the spread of the COVID-19 Delta variant to keep volatility at an elevated level.
Global M&A hit $1.5 trillion in value—a record high—and the U.S. led the pack with five of the ten largest deals. Arbitrage spreads narrowed during the quarter and widened in late June, reaching as high as 20%. While we expect a brief summer pause, we anticipate elevated activity levels for the rest of the year. Private equity sponsors are benefiting from equity market performance and record fundraising, with U.S. PE dry powder sitting at $150.1 billion. As companies work to prepare for the post-pandemic world, we believe the environment is ripe for M&A and offers a rich opportunity set for arbitrageurs.
Turning to real estate, the global economic recovery supported an improvement in fundamentals across most real estate sectors in the second quarter. As the world’s population has begun to revert to more normalized behavior and usage of real estate, some of the uncertainty that has been pervasive in the market over the last 18 months has dissipated. Broadly speaking, real estate pricing has improved substantially since the low points of the pandemic. Private real estate is currently significantly undervalued as compared to corporate bonds, which we believe has driven more capital to real estate on a relative value trade given the historically low-rate environment. Housing and industrial properties have continued to demonstrate resilience, while certain segments of hospitality and necessity-based retail properties have started showing significant signs of recovery. However, uncertainty remains in office as well as certain segments of retail and corporate-focused hospitality properties, particularly in gateway markets.
In the U.S., continued progress toward “normal” and the Fed’s implicit support for maintaining low rates—even in the face of inflationary indicators—have driven tremendous economic growth. Transaction volumes increased substantially in the second quarter, and some segments of the real estate market have exceeded pre-pandemic volumes—namely multifamily and industrial. Additionally, low interest rates and increased availability of financing have supported investment and refinancing activity. With regard to valuations, the Green Street Commercial Property Price Index increased 11% year-over-year and is now only 1% behind pre-pandemic levels, but significant variation by property type still exists.
In Europe, the economy has shown signs of recovery, with many returning to workplaces, going out to eat, and booking travel. Unemployment has decreased substantially, and government programs to support healthy employment levels are expected to continue. However, real estate activity continues to be somewhat stagnant in the region, and European non-performing loan sales grew in the second quarter after consistently declining from peak levels since 2014. With economies hopefully continuing to reopen over the coming months, fundamentals and transaction volumes are expected to show signs of improvement across the continent.
Asian economies—which previously led the global recovery—are now facing headwinds driven by a resurgence of COVID-19 cases as the region’s vaccination rollout lags. Although 2021 GDP growth is still expected to be robust in Japan, South Korea, and China, government lockdowns and related restrictions have slowed the economic recovery. Despite this slowdown, fundamentals remain strong in both office and logistics across the region, which has provided support for the broader real estate market in Asia.