Volatility brings credit opportunities as solvency remains stable

Corporate bond markets are coping well given that the supply-side shock from the Russia-Ukraine war is impacting earnings and not solvency. Sentiment has still deteriorated, but this has driven spreads wider and presented opportunities among high-quality issuers. How can investors identify these opportunities? This report which is the fourth part of our latest quarterly assessment of global fixed-income markets, Alphorum, explores some answers.

In our previous reports in this series, we focused on what fixed-income scenarios could result from the current market shock, what the central bank’s war on inflation means for developed-world bond markets and the new duality within the sovereign Emerging Market universe. Going forward, we will explore insights into the dynamics driving sustainable fixed income and systematic research.

Fundamentals and macro

Given the negative impact on stock markets (at least in the short term), the casual observer might expect corporate credit to have suffered equally in the wake of Russia’s invasion of Ukraine. In reality, while there have been some consequences for corporate fixed income, the implications for the two asset classes differ. 

The key point here is that this is a shock to earnings rather than a solvency shock. The pain was therefore always going to be felt more strongly on the equity side. Our research shows that corporate bond markets tend to rebound quite quickly from conflict-related crises, which do not in themselves tend to create significant credit risk. With most companies’ underlying fundamentals in reasonably good shape, corporate fixed income should continue to weather the crisis quite well, in our view.

Higher commodity and energy prices are of course impacting corporates – with some sectors and companies worse affected than others. Energy utility EDF¹ is a slightly surprising example, which is suffering due to its inability to pass on higher prices to its customers. In fact, the French government required the utilities firm to make more and cheaper energy available to consumers, just as underinvestment means production from their nuclear power plants is lower. Ironically, this could prove positive for credit as EDF is 85% owned by the French state, which is likely to be forced into supporting the company. Alongside rising input costs, the risks to already-stretched supply chains mean onshoring is likely to accelerate; this will add another cost layer for many firms.

However, for most of the corporate universe, exposure to Russia is more significant as a reputational issue than as an existential one. Hence the number of companies suspending their operations in the country, or at least indicating that they are likely to. Renault Group was one notable exception, which tried to continue production in the Moscow plant of its profitable Avtovaz subsidiary (which includes Lada), but finally succumbed to a combination of supply issues and political pressure.

Sentiment

Sentiment and positioning have undoubtedly deteriorated, with outflows across credit. We believe that many investors are being overly cautious, either regarding firms’ degree of direct exposure to Russia or about the scale of second- and third-order effects. We would therefore regard this as more of an opportunity than a threat. Having said that, there will be ongoing earnings shocks over the coming quarters, particularly for companies that have failed to hedge their energy use effectively, are suffering from continuing supply bottlenecks, or who simply see the crisis as an opportunity to excuse poor operational performance. European businesses are most vulnerable, with US companies, which tend to have a strong domestic focus, less affected. The market has priced this in, to some extent, but the impact could end up being stronger than expected for some firms.

Lower risk appetite means the first new issues in the wake of the shock are from higher quality names and often offer generous new-issue premiums. This can provide an opportunity to add positions defensively by taking advantage of attractive yields from high-quality issuers and allocating higher up the capital structure.

Technicals

Post-covid capex is now likely to be bolstered by additional government defence and energy spending, as well as by investment in onshoring and repairing supply chains. This is likely to also be debt-funded and should increase supply going forward. Second- and third-order effects of the war in Ukraine, particularly the impact on earnings of higher commodity and energy prices, may increase the likelihood of new fallen angels, or bonds that have been downgraded from investment-grade to high-yield status, with most rated BB or BB+. This is something we are actively evaluating, assessing the underlying fundamentals of candidate companies to be ready for potential opportunities.

Valuation

The geopolitical environment has worsened a situation where rate moves (and expected rate moves) and supply chain constraints were already a problem, resulting in widening spreads, falling prices and higher yields. Valuations are now attractive on an absolute level but are likely to remain volatile as long as geopolitical risks remain elevated. Once these stabilise however, we believe credit spreads offer attractive entry points.

The challenge in identifying opportunities is in disentangling these multiple drivers. For example, if a company has materially underperformed due to its overexposure to energy prices, that is a reason not to buy. However, if material underperformance is due to its location in Eastern Europe, or because a percentage of its sales are in Russia, but there is no major risk of default or a ratings action, the firm’s bonds could represent a real opportunity.

Outlook

Going forward, corporates can certainly expect a tougher, more competitive environment. Companies’ ability to quickly pass on rising input costs will be particularly important. However, whole sectors have moved in terms of valuations based on their exposure to higher energy prices (see chart); within them, there will be those firms whose individual situation makes them better placed to cope. The same is true regarding exposure to supply-chain disruption, or for cyclical sectors, the potential fall in demand due to rising inflation. For the latter, there are some counterintuitive examples – in an inflationary environment in which real income is falling, many consumers are likely to put off major expenditure like buying a car. However, the last two years of stay-at-home government guidance have made the prospect of a summer holiday something few consumers are likely to be willing to forego now, making the short-term outlook for many businesses in travel and hospitality surprisingly rosy.

FIG 1. Exposure to higher energy prices by sector

Source: JP Morgan as at 2022. 

While some ratings downgrades are inevitable among the fallout from the Ukraine conflict, only the most indebted and ill-prepared companies are in any serious danger in the current circumstances. Geopolitics will almost inevitably keep volatility elevated and increase downside risk, but valuations offer some cushion and fundamentals are quite strong.

Finally, it’s worth noting that high energy prices are emphasising the need for a green-power revolution, with the transition likely to accelerate – albeit high prices for metals crucial to renewables infrastructure pose a short-term challenge. In this environment, sectors and companies able to reduce their energy use, pass on higher input costs and ‘go local’ will prevail, in our view.

To read the full Q2 2022 issue of Alphorum, please use the download button provided.

Learn more about our fixed income strategies here.

NUR FÜR PROFESSIONELLE INVESTOREN

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