Janus Henderson Investors’ Credit Risk Monitor tracks key indicators which impact credit portfolios
All three traffic lights monitored by Janus Henderson Investors’ credit team continued to flash red in Q4 2022, as the cycle is deteriorating, but the inflation wildcard has lessened the risk that policymakers will need to engineer a hard landing to cool inflation.
Thus, the potential for a soft landing has increased, but Janus Henderson’s credit fund managers remain cautious as the economic outcome remains uncertain and the retreat in inflation comes too late to forestall further deterioration in the credit cycle.
Analysis shows this phase of the credit cycle will be driven by deteriorating fundamentals.
Whether dispersion between industries and sector is set to increase will depend on the eventual economic outcome, leaving opportunities and risks for active investors to navigate.
06 February 2023, London – Corporate credit fundamentals are likely to worsen this year as earnings’ weakness deepens, despite signs that headline inflation has passed its peak and improved chances for an economic soft landing, according to the latest analysis from Janus Henderson Investors.
Asset Class Outlook
While credit had an improved fourth quarter, producing positive total returns as spreads tightened with optimism that peak inflation had passed, deteriorating fundamentals signal caution for investors.
The asset class is in a strong position to deal with this stage of the credit cycle for investors who can navigate the asymmetry of credit markets where downside corrections can be severe.
Surpassing a peak in headline inflation in many economies has buoyed market sentiment around the probability of a soft landing and propped up expectations of a pivot or pause in monetary policy tightening.
Nevertheless, significant weakness in core inflation is yet to be seen and remains a concern for central banks who have deliberately communicated that it’s too early to step off the brakes.
As such, issuer dispersion is likely to continue in 2023, but if recession is avoided, correlations may increase.
Janus Henderson Investors’ latest Credit Risk Monitor tracks corporate fundamental and macroeconomic indicators on a traffic light system to indicate where we are in the credit cycle and how to position portfolios accordingly. The key indicators tracked (‘Cashflow and Earnings’, ‘Debt Loads and Servicing’, and ‘Access to Capital Markets’) all remain red.
Janus Henderson Credit Risk Monitor
|Access to capital markets
|Cashflow and earnings
Earnings growth set to weaken, with energy and input costs impacting cashflow
‘Cashflow/ Earnings’ indicator remains red
- Key metrics: earnings, earnings revisions
Earnings appear to have peaked and earnings revisions are expected to turn more negative – all regions saw flat or negative forecast revisions for 2023 over the last three months. At the same time, stubbornly high energy and input costs continue to impact cashflow. However, a soft landing or shallow recession is baked in, as 2024 earnings are expected to rebound, significantly so in emerging markets. This earnings normalisation has begun to affect credit fundamentals in certain areas which we expect to broaden, but these remain favourable given strong starting points.
Liquidity trends are fading fast but primary market activity remains buoyant
‘Access to Capital Markets’ indicator remains red
- Key metrics: liquidity cycle, real borrowing costs
Clearer recession signals have emerged from economic activity data as well as money trends and yield curves moved deeper into inversion territory, while central bank liquidity continues to be withdrawn from the system. Real rates spiked signalling high borrowing costs, but primary market issuance has been buoyant and readily absorbed. Supply in high yield, in contrast, has been more limited which has been a supportive technical for valuations. Compression – or the outperformance of lower quality paper – continued in the rally. The demand for credit is strong.
Debt is everywhere, however interest costs remain controlled
‘Debt Loads and Servicing’ indicator remains red
- Key metrics: interest cover, leverage
Earnings weakness has further to go. So issuer fundamentals remain resilient for now, but weakness in broad fundamental metrics data is expected to seep through in the second half of the year. When we start to get weaker consumer confidence and interest rates really bite into the economy, we’d expect some of that corporate margin decline to come through.
Jim Cielinski, Global Head of Fixed Income at Janus Henderson Investors, said:
“Our credit risk monitor is by design focused on cyclical elements and not valuation. As spreads contracted last quarter, it should be evident that our cycle indicator is suggesting that this rally is not likely sustainable. We expect fundamental weakness to proliferate as we move through 2023. Optimism in a central bank retreat has allowed markets to reopen, but this too may prove fleeting. As inflation retreats, real rates will rise, and an inability to borrow at heavily subsidised levels of real rates will worsen the default outlook. We are not out of the woods yet, although the decline in inflation seen in the last three months is a critical prerequisite to the elusive soft landing that investors cherish.
So we still think the cycle is deteriorating, but the inflation wildcard has lessened the risk that policymakers are forced to severely break things. At the margin, the retreat in inflation is a very welcome event and it may soften the severity of the downturn, but it comes too late to forestall further deterioration in the cycle.”
James Briggs, Portfolio Manager at Janus Henderson Investors: “Whether we see more dispersion in credit markets from here is dependent on whether a soft or hard landing is achieved. If a soft landing occurs, like the market expects, compression and therefore correlations could increase. If a hard landing, we would expect to see further dispersion as we go through into the second half of this year. Careful security selection and building resilience into credit portfolios will be key to navigating this part of the credit cycle.”
Anil Shenoy, Head of UK Institutional Clients at Janus Henderson Investors said: “UK Defined Benefit pension schemes are large investors in corporate bonds and we expect allocations to increase following the recent volatility in the Gilt market, as they continue to mature and review their strategic asset allocations. This means pension schemes are increasingly exposed to credit risk; we see the Janus Henderson Credit Risk Monitor as a tool for Trustees and their advisors to understand the current level of this risk through some of the key metrics used by Jim and the Credit Team.
The deteriorating credit fundamentals means Trustees have an opportunity to review investment guidelines for buy and maintain portfolios, in order to give managers sufficient freedom to take advantage of the expected dispersion as well as avoid being an unintended forced seller of corporate bonds that the manager still expects to be money good. Having a regular dialogue with your manager is key.”
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Notes to editors
Janus Henderson Group is a leading global active asset manager dedicated to helping investors achieve long-term financial goals through a broad range of investment solutions, including equities, fixed income, multi-asset, and alternative asset class strategies.
As of December 31, 2022, Janus Henderson had approximately US$287 billion in assets under management, more than 2,000 employees, and offices in 23 cities worldwide. Headquartered in London, the company is listed on the NYSE and the ASX.
About the Credit Risk Monitor
Janus Henderson Investors’ Credit Risk Monitor was first created in recognition of the growing reliance that pension schemes, and UK pension schemes in particular, had on corporate bonds, in order to pay pension scheme members. As UK pension schemes continue to mature, this reliance on corporate bonds is likely to increase. The Credit Risk Monitor has been designed to help Trustees and their advisors understand how the credit cycle has developed and the key risks of which to be aware. It tracks corporate fundamental and macroeconomic indicators on a traffic light system to indicate of where we are in the credit cycle and how to position portfolios accordingly.
The indicators include debt loads and servicing (interest coverage ratios), access to capital markets and cashflow/ earnings.
Why the credit cycle matters
Historically, corporate credit excess returns have been positive two-thirds of the time or more*, but investors must bear the asymmetry of credit markets where downside corrections can be severe.
Monitoring the credit cycle and top-down risks is good risk management. The challenge for investors is that every cycle is different and requires a combination of data and judgement.
No single indicator or dataset can be reliable in isolation, and the lags are uncertain. However, by considering the credit cycle within a framework and assessing the weight of evidence from the key metrics shown here, we can better understand the balance of risks and potential turning points.
*Based on quarterly excess returns on global investment grade and high yield indices since 1999.
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