Credit’s response as the policy brakes tighten
As central banks seek to put the brakes on higher inflation, Tom Ross, Corporate Credit Portfolio Manager, considers three things that concern him about credit markets and three things that excite him.
KEY TAKEAWAYS
- Tighter monetary policy initially manifested itself though higher yields, but rising growth concerns have contributed to wider credit spreads.
- Markets are pricing in the potential for some slowdown of the economy, but we would expect spreads to widen further if a recession becomes more certain.
- In terms of credit fundamentals, i.e., strength of balance sheets, companies are in reasonable shape, and with valuations now more attractive, opportunities are opening up for investors prepared to take a selective approach.
KEY TAKEAWAYS
- Tighter monetary policy initially manifested itself though higher yields, but rising growth concerns have contributed to wider credit spreads.
- Markets are pricing in the potential for some slowdown of the economy, but we would expect spreads to widen further if a recession becomes more certain.
- In terms of credit fundamentals, i.e., strength of balance sheets, companies are in reasonable shape, and with valuations now more attractive, opportunities are opening up for investors prepared to take a selective approach.
Views as of early June 2022.
What three things concern you most about credit?
Given the current volatility in markets, we wanted to update you on the three things that are concerning us around the credit markets. Firstly is growth. We believe growth has peaked and we're expecting a slowdown in growth. The key question from here is the magnitude of that slowdown and ultimately will that lead through into a recession. And also the severity of that recession.
Secondly is inflation. Now inflation can be both positive and negative, and some sectors can benefit from that. But at the moment, the combination of both higher wages, higher input costs, is having a huge number of impacts across many different sectors and really causing a struggle for some companies to be able to pass on those input costs through onto their customers.
And then finally, central bank tightening, which is obviously a function of the inflation that we're seeing coming through in the markets.
What three things excite you the most?
But volatility isn't all negative and there are some things that are exciting us about the credit markets right now. Firstly is valuations. We have better valuations now. Spreads are wider and we also have higher all-in yields, which will be attractive to many investors.
Secondly is the point around the diversifying benefits of fixed income. We've had for a number of years now, with the very low all-in yields, obviously that lack of ability to protect and for duration to be able to protect against sell-offs in risk assets. But now with these higher yields, actually now we have an ability where that might start to work in a more uncorrelated fashion, i.e., bond prices going up as risky assets sell off.
And then finally, volatility provides opportunity and especially in terms of security selection and picking those companies that will better see through these opportunities. Obviously, clearly, more dispersion in terms of valuation is also providing opportunities not just at the securities level, but at the sector level and also on a regional basis as well.
Is credit pricing in a recession?
So are credit markets pricing in a recession? Well, as spreads have widened, clearly, that probability of recession has increased. But we would say we’re not yet pricing in any meaningful recession at any point sort of globally. Europe is pricing in a higher probability of recession as those spreads have widened more. But we’re probably getting close to pricing in maybe a very mild or a small technical recession, but nothing more meaningful than that as yet. Within the US, given the lower impact of higher energy costs relative to Europe, we haven't quite seen exactly the same level of spread widening. And so therefore, the pricing of recession there is probably slightly less. We're probably talking around 30% to 40% chance of a recession in the next sort of 12 to 18 months.
Now, why is trying to price a recession, why is that important for credit markets? Well obviously a recession, low growth leads through to high defaults, which is also then what will take away from credit market expectations and returns. And I guess the positive view here is that whilst we absolutely expect default rates will rise from here from very, very low levels, the positive is the companies are actually in pretty good shape in terms of their balance sheets and have termed out their debt. There shouldn't be too much of an issue in terms of liquidity really causing a default. It's really going to have to be some kind of meaningful recession that will ultimately lead through to any significant spike in default rates, in our opinion.
Is there a tipping point where investors favour high yield over loans?
So, is there a tipping point where investors favour high yield over loans? Well, up until this point, investors have tended to favour loans, most notably because of their floating rate nature in a rising rate environment. Now as we look forward, now, we have arguably greater valuations within high yield, both in terms of spreads, because investors haven't necessarily wanted to invest there, but also in terms of those all-in yields, given the underlying rates move as well. So, valuations are also more compelling, we would argue, within the high yield market. Also the case as well for loans, that being floating rate, the issuers of those loans are now having to pay higher interest costs, which obviously is putting a greater stress upon their balance sheets. So, we believe that tipping point is arguably quite close, and investors should be thinking much, much harder about their allocation between loans and high yield.
How might quantitative tightening affect credit markets?
So, we’re increasingly hearing about quantitative tightening within the market and its potential impact through on to credit markets. So quantitative tightening is central banks, all of the bonds that they've purchased, it's whether they're now selling those bonds or simply allowing them to mature. Now, the majority of quantitative easing, the buying of those bonds, has been focused globally in more government bond markets. However, we also do have the ECB that was also a very large buyer of corporate bonds, and obviously losing that price insensitive buyer has to be a negative through onto credit markets. And going forward, obviously, we need a new [net] buyer to replace the central bank buyer that we've now lost. And with higher yields now we have the potential for new investors to come into the market and also the potential for a switch from equities into fixed income – especially now that fixed income is providing a better diversifying benefit for portfolios – in order to take up the slack from the central banks and their prior purchases.
Credit markets: A catch-all term used to describe debt securities issued by companies, such as corporate bonds.
Credit spread/spread: The difference in yield between securities of similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due. The default rate is a measure of defaults over a set period as a proportion of debt originally issued.
Dispersion: This describes the range of returns on a single security or wider market. More dispersion indicates a more volatile market.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Duration: Measure of a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
ECB: European Central Bank, the central bank of the Eurozone.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or "junk" bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
Inflation: The annual rate of change in prices, typically expressed as a percentage rate.
Loans/bank loans: Privately issued debt from non-investment grade companies, generally secured against company assets and that rank first in priority of payment. Interest payments are floating rate, i.e., the interest paid to an investor changes to reflect a reference rate such as a money market rate.
Quantitative easing: An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system. A key method has been to create money and use this to purchase securities such as bonds. Quantitative tightening is the reverse where the central bank shrinks its balance sheet and the money supply by not reinvesting the maturing securities it holds or actively selling them.
Risk assets: Financial securities that can have significant price movements (hence carry a greater degree of risk). Examples include equities, commodities, property and lower-rated bonds.
Volatility: The rate and extent at which the price of a portfolio, security or index moves up and down. Volatility measures the dispersion of returns for a given investment
Yield: The level of income on a security, typically expressed as a percentage rate. At its most simple for a bond, this is calculated as the annual coupon payment divided by the current bond price. All-in yield accounts for the combination of coupon income, credit spread movement and change in principal as a bond nears maturity.