Reality check: corporate credit exits the twilight zone

With higher interest rates, lower growth expectations and credit-rating downgrades on the horizon, the new environment for companies contrasts starkly with conditions shaped by years of ultra-accommodative monetary policy. In the corporate-credit section of Alphorum, our fixed-income quarterly, we assess risk and return drivers in this new reality.

Fundamentals and macro

For a long time, credit markets, in common with much of the investment universe, have existed in a sort of economic twilight zone where ‘normal’ rules do not apply. With central banks acting as buyers of last resort almost regardless of ratings, investment-grade bonds in particular have shown little or no dispersion in relation to credit quality. Seeking returns, investors have been driven ever further down into the high-yield market.

Credit could never exist in this existential limbo forever. As persistently stronger inflation has turned the Federal Reserve hawkish and forced the European Central Bank to shift towards quantitative tightening in preparation to hike rates, credit markets have experienced a reality check. In time, it should lead to healthy differentiation for quality across sectors. But first the market needs to learn how to price credit risk again.

Effectively, the removal of quantitative easing means financial markets that have been walking on crutches for years are having to remember how to stand on their own two feet. In the long term , we think that is no bad thing, but it is coinciding with further disruptions. With inflation continuing to be driven upwards by high energy and food prices, disposable income falling, supply chains still struggling and growth stalling, there will be some pain to endure before the prognosis improves. In the short term, ratings drift remains positive, largely supported by strong corporate balance sheets, but agencies are becoming more conservative as the environment deteriorates (see figure 1).

FIG 1. Credit-ratings drift since January 2019 (upgrades vs downgrades, %)

Source: Bloomberg, Bank of America and Morgan Stanley, as of 31 May 2022.

Sentiment

While opportunistic short-term shifts in risk appetite may occur, overall market sentiment remains weak and volatile. High-yield funds are seeing inflows, particularly in the US. At the same time, high-yield supply has resurfaced, albeit only for higher quality issuers, while the primary market remains selectively open for investment-grade names at a premium. However, it is still too early to foresee a clear change in momentum.

Despite this, our view is that the macro environment is being distorted by the Russia-Ukraine conflict – remove this from the equation and we are essentially experiencing a long-needed period of normalisation. The accommodative era is finally being brought to an end, but with ample support being provided for so long, removing it was always going to create some short-term drama.

Technicals

From a technical standpoint, normalisation is on track. Swift market repricing has translated into a rapid increase in real rates, tightening financial conditions aggressively. Meanwhile, post-Covid capex planning has been rising and is now being complemented by further spending needs for defence, energy (with a focus on renewables) and onshoring of manufacturing capacity, as the global economy seeks to adapts to the impact of the war in Ukraine.

Valuations

From a relative-value perspective, across the credit universe both in Europe and the US, spread ratios still favour going higher in quality, in our view. Europe looks superficially attractive versus the US, however a lagging recovery, peripheral risk and disadvantageous sector exposure represent clear vulnerabilities. All-in yields are now attractive, but we believe that volatility will remain elevated.

Outlook

Despite the challenging macro environment, the fixed-income universe is somewhat insulated from the full impact of rising rates. While companies will be forced to pay a higher interest rate when replacing maturing bonds, in our view any new issuance will likely represent a smaller proportion of their overall debt stack. Interest cover has historically been so high that it will take a long time to deteriorate. As a result, initially the impact is more likely to be seen in EBITDA than in interest costs.

Having said that, analysts have started to revise their default-rate forecasts upwards somewhat for 2022, and even more so for 2023. We expect a rise in downgrades to result in a return to positive net supply of fallen angels at healthy levels. As explained in the Systematic Research section of this issue of Alphorum, that should lead to a period of structural outperformance for this sub-asset class. Effective fundamental analysis and careful due diligence will be important in catching fallen angels, not falling knives. Nevertheless, the appealing valuations and strong achievable yields characteristic of this market segment make this as an opportune time to invest, in our view – especially because investors who are active in this space before the downgrades happen are likely to be better positioned to capture opportunities. An example of the type of business which fits our criteria for an attractive fallen angel is UPL¹, an Indian chemical company which was downgraded in May largely as a consequence of the local environment, not its credit risks, but for whom our analysis finds the situation is manageable.

More generally, we would tend to avoid businesses with high energy requirements, complex global supply chains, or those that struggle to pass through higher inflation costs. Conversely, we remain constructive on companies with the liquidity and financial resources to withstand the situation until the market normalises. We see the energy transition accelerating further, emphasising the attractiveness of green and sustainability-linked bonds. At the same time, as inflation continues, pricing power will be particularly important, along with business models which are sustainable in the evolving macro environment.

With the end of stimulus delivering a reality check, companies and investors with the sharpest senses are most likely to adapt.

Discover more about our fixed income strategies here.

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Source.

[1] Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

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