Global investment grade: a bumpy road to pivot
As it appears we have passed an inflation peak in the US, markets have anticipated this may be the rollover that precedes the pivot. Portfolio manager James Briggs discusses how navigating this part of the cycle requires caution.
7 minute read
- Markets are eager to call the inflection point that signals the need to reposition for the next leg of the cycle – the crucial policy pivot.
- Pervasive optimism may dissipate as downgrades occur and defaults overshoot some market participants’ expectations in 2023.
- Navigating this part of the cycle requires caution, in our view, but with the shift higher in yields investors are now better compensated for holding high-quality assets.
Not broken the back of inflation – yet
The potential passing of peak inflation in the US has reinvigorated risk assets into a widespread frenzy. Positively, this moderation in inflation increases the chance of a soft economic landing. As the US is considered a leader of the rest of world, this explains the pervasive market optimism. However, surpassing a peak does not seem to be on the near-term horizon for Europe or the UK, making this only one, albeit important, datapoint. We are not yet at a stage where there is enough data to suggest repositioning for the next leg of the cycle – in other words, the eagerly anticipated pivot.
Looking behind the figures, weakness has emerged in goods, such as clothing, as high inventory led to discounting. This implies that lower corporate margins, weaker economic growth and eventually layoffs may accompany the eagerly awaited relief on inflation. This could be the rollover that markets are anticipating, but the magnitude of the reaction signals that it may have been taken too optimistically as a positive for growth and employment.
Such buoyancy gives impetus for further investment grade (IG) supply in the primary market, risking investors becoming over-extended. So, when the growth slowdown and higher unemployment takes hold as the lagging effect of monetary policy materialises in data, this could be akin to coming off a sugar high.
Too much optimism on defaults
As we move towards what could be “the most anticipated recession ever”, some market participants appear to be underestimating the risk of fallen angels – where IG companies are downgraded to high yield. According to Barclays, however, downgrades in 2023 could outpace upgrades for the first time since 2020, specifically US$60-80bn of fallen angels against US$60-70bn of rising stars. Lower earnings revisions are broadening out beyond the energy and chemicals sectors, as more sectors feel the pinch from the consumer spending slowdown. But mixed earnings from bellwethers, such as big box retailers, provide a murky picture. Some participants also expect defaults to creep up gently to a benign 2%, but many of these forecasts are not compatible with the magnitude of tightening we have seen in monetary policy and financial conditions.
Considering macroeconomic variables, these indicate defaults could overshoot expectations, which we believe signals that investors should be cautious in navigating this late cycle environment. The most recent US Federal Reserve (Fed) senior loan officer survey, for example, reported a further weakening of credit demand and tighter lending standards, consistent with the picture in Europe and the UK. The survey has historically shown strong correlation with default rates – despite a deliberate undershoot as part of the one-off COVID policy response – as shown in Figure 1.
Figure 1: Tighter lending standards correlate with default rates
Source: Bloomberg (senior loan officer survey) and Moody’s for (US speculative grade default rate), 31 October 2022. The senior loan officer survey of up to 80 large domestic banks and 24 US branches and agencies of foreign banks is a barometer of credit demand and lending standards, where the percentage above shows the net percentage of domestic respondents tightening standards – commercial & industrial (C&I) loans for large- and medium-sized businesses. A negative number implies looser lending standards.
Systemic risk underestimated?
A robust argument can be made that fundamental default risk is now well priced into credit markets, but the underperformance of less vanilla assets such as mortgage-backed securities (MBS) and real estate investment trusts (REITs) highlights that there is more under the surface that needs analysis. As liquidity is withdrawn from the financial system, access to capital comes into focus, along with the transparency of businesses or financial structures, visibility of cashflows and corporate governance. While there is no near-term refinancing cliff to cause a default spike, maturity profiles are not unusually extended and refinancing will remain a significant feature in 2023. With allocations to less- liquid markets – including private credit, direct real estate and infrastructure – still elevated, systemic risk may be underappreciated. Surprise refinancing from asset classes outside of but close to credit, such as private debt or hung bridge loans1, can still emerge as can black swan events, with the effects of capital destruction from the blow-up in crypto markets and the troubles in Chinese property still working their way through the system.
An associated risk during periods of uncertainty is the optionality embedded in subordinated bonds, particularly around coupon deferral or maturity extension. While the expectation remains that most of this debt will be retired at the first call date, this assumption continues to be challenged, most notably by regulators in the financial sector. Top tier global banks have recently considered extending callable debt, even for senior bonds with a one-year maturity extension. While the economic impact of this for bondholders is limited, such precedents could open the door for more punitive actions as issuers take an economic approach rather than conforming to market norms.
In our view, such optionality introduces additional risk that is yet to be fully priced. The market has become somewhat bifurcated with the material underperformance of non-bank financials or asset-backed sectors. However, we believe that risk-adjusted returns continue to look more attractive at the higher-quality end of the credit spectrum, with only a modest outperformance of defensives relative to cyclicals and the spread differential between higher-rated credit and lower BBB- or BB-rated debt not yet suggesting a significant growth slowdown. We like the outlook for senior bank debt which screens materially better value than non-financials. However, this is an over-owned part of the market, with many investors attributing this ‘cheapness’ to purely technical factors – such as additional supply – while the impact of a potential slowdown in the housing market is somewhat overlooked. The flattening of yield curves has created potentially significant value at the front end of the curve. Capturing high quality debt at yields of 6-7% is now possible, which means there is no need to overextend risk to find adequate compensation for holding an asset.
IG yields are better than we have seen in decades, with spreads now compensating for credit risk, albeit perhaps not yet additional premium for further volatility as the outlook becomes more challenging in 2023. Notably, IG is pricing more recession risk than HY, increasing its relative attractiveness. Peak inflation also means peak yields, and as the cycle turns, with growth slowing and inflation coming down, yields are likely to decline, amassing capital gains. Euro IG corporate bonds are pricing in more downside and recession risk, relative to US dollar IG corporates2. This is despite the expectation that US default rates will overshoot those in Europe and this may present mispricing opportunities3.
A rocky ride
Undoubtedly, it is likely to be a rocky road ahead as markets balance optimism with reality. The shape of this slowdown is unlikely to be similar to the pandemic, where central banks rode to the rescue. With the quantitative easing (QE) backstop in the past, we believe it could take 18- 24 months to get inflation under control. While markets are eagerly trying to call the inflection point, we believe there will be further episodes of volatility before a turn in the cycle.
Figure 2: Gilt liquidity has fallen off a cliff
Source: Bank of America, 10 November 2022. There is no guarantee that past trends will continue or forecasts will be realised.
One way to view markets is to consider the sharp deterioration of liquidity in the UK gilt market over this year, then tallying this with the optimism seen post the recent inflation data in government bonds. In the US, comparatively, such sharp moves have only been seen five times over the last 30 years. Four times during the Global Financial Crisis (GFC) and once in 1995 with then Fed Chair Alan Greenspan‘s policy reversal. Investors should expect a different playbook than the rear-view mirror perspective of the last couple of years. Data suggests volatility may be with us for a while yet and while market rallies and corrections can be significant, we should tread with care when allowing market moves to dictate a new narrative. A cautious approach therefore feels warranted to navigating through this cycle.
1 Hung deals typically occur when a bank provides bridge financing on an acquisition, expecting that loan to be refinanced in the bond market.
2 Source: Bloomberg, JP Morgan. Uses data from last 6 months and compares to historical drawdowns. As at 21 November 2022.
3 Source: Moody’s, US and Europe speculative grade default rate forecast, 31 October 2022.
4 Source: Bloomberg, 11 November 2022. US 5-year Treasury yields.
Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Yield: The level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price.
Investment-grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high-yield bonds.
High yield bond: A bond which has a lower credit rating below an investment grade bond. It is sometimes known as a sub-investment grade bond. These bonds usually carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.
Late-cycle: Asset performance is often driven largely by cyclical factors tied to the state of the economy. Economies and markets are cyclical and the cycles can last from a few years to nearly a decade. Generally speaking, early cycle is when the economy transitions from recession to recovery; mid-cycle is when recovery picks up speed while in the late cycle growth slows, wages start to rise and inflation begins to pick up. At this stage, investors become invariably bullish believing that prices will continue to rise.
Mortgage-backed security (MBS): A security which is secured (or ‘backed’) by a collection of mortgages. Investors receive periodic payments derived from the underlying mortgages, similar to coupons. Similar to an asset-backed security.
Real estate investment trust (REITs): An investment vehicle that invests in real estate, through direct ownership of property assets, property shares or mortgages. As they are listed on a stock exchange, REITs are usually highly liquid and trade like a normal share.
Callable bond: A debt security that can be redeemed early by the issuer before its maturity at the issuer’s discretion.
Corporate hybrid: Subordinated debt instruments that combine the features of pure equities and pure bonds.
Senior debt: Money owed by a company that has first claims on the company’s cashflows. Subordinated debt is any debt that falls under, or behind, senior debt.
Yield curve: A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.
Credit spreads: The difference in the yield of corporate bonds over equivalent government bonds.
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.
Coupon: A regular interest payment that is paid on a bond. It is described as a percentage of the face value of an investment. For example, if a bond has a face value of £100 and a 5% annual coupon, the bond will pay £5 a year in interest.
Liquidity: The ability to buy or sell a particular security or asset in the market. Assets that can be easily traded in the market (without causing a major price move) are referred to as ‘liquid’.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. Higher volatility means the higher the risk of the investment.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money. See also fiscal policy.
Premium: When the market price of a security is thought to be more than its underlying value, it is said to be ‘trading at a premium’.
Black swan events: Highly unusual, unpredictable events that carry a severe impact.