Moving into 2022, we are constructive but vigilant on credit

As we progress into 2022, are credit markets complacent? Despite a constructive backdrop for corporate bonds, we remain vigilant. This report is part of our latest quarterly assessment of global fixed-income markets, Alphorum. In the coming days, we will focus on emerging markets, sustainable fixed income and systematic research. 

Fundamentals and macro

As yet we are not seeing ‘late-cycle’ dynamics for credit; default risk remains low, while upgrades continue to outpace downgrades. Meanwhile, capex and hence the growth outlook appear neutral. For most companies, Q3 earnings were strong; cost pressures includ-ing labour, energy (particularly European gas) and raw materials were flagged, while supply-chain bottlenecks continued to cause prob-lems in some sectors. However, these were largely offset by strong demand. Flash composite purchasing managers indices for Decem-ber 2021 show activity continuing to slow but remaining expansionary. 

Markets initially priced in Omicron as being a limited risk. This is likely to have been partly because repeated crises tend to have progres-sively less effect on sentiment, so that the market had become largely immune to Covid. There may also have been an expectation that this would be the variant which transitioned us into living with the disease as endemic. The sheer pace of the rising wave of cases is causing governments to react in ways which may yet affect fixed income. However, there is an argument that even further prolonged lockdowns or a more virulent variant have potential upside for the bond market, as governments step in to provide support and stimulus. 

Despite the overall constructive environment for credit, though, uncertainty remains. The Fed’s announcement in December signalled an end to quantitative easing in March 2022 and opened the door to a rate hike thereafter, neither of which are positive for fixed income. A more insular China also feels like a risk for foreign investors, as do the ongoing issues in Chinese real estate. Finally, geopolitical issues, particularly the potential for conflict between China and Taiwan and also Russia and Ukraine, are a concern. While these issues seem to be contained so far, we will continue to monitor them closely.

Sentiment

As expected, sentiment and hence positioning became more neutral again in the final quarter of 2021, reducing the risk of positioning-related market moves. Inflows were primarily from redemptions and coupon reinvestments, while supply remained high. Even the announcement from the Fed of an acceleration of tapering and up to three interest rate rises in 2022 passed with limited reaction. Investors seem more and more happy to look through market events — but are credit markets complacent?

Technicals

More hawkish central bank policy is inevitably a concern. The Fed is now poised to rapidly curtail monthly asset purchases, which is likely to weigh on the investment grade bond market and could lead to a liquidity drain. By comparison, the ECB is taking a more dovish approach, rolling back crisis-era stimulus but promising to hold down borrowing costs and keeping the door open to further support.

We expect net supply in investment grade to increase, driven by capex and lower levels of excess cash (Figure 1), mainly due to the return of capital to shareholders. Meanwhile, high-yield bond supply should stabilise in 2022, after a record year in terms of issuance volume in 2021.

Figure 1. Investment grade net supply vs US capex ratio

Source: BNP Paribas, Bloomberg as at December 2021. For illustrative purposes only.

Valuation

Tight investment grade spreads offer little protection through carry. High yield remains attractive over other fixed income segments, as the higher credit spread offers more ‘protection’ in a rising rate environment. Buoyant high yield valuations are partly explained by higher quality, as improving fundamentals translate into more rising star candidates. Having said that, the European high yield segment underperformed in the final quarter of 2021, due to its lower exposure to energy compared to the US. As interest rates rise in 2022, the appeal of high yield over investment grade is likely to continue.

Outlook

While we are not unduly pessimistic, we expect the environment to be tougher for credit in 2022. There are a number of negative externalities and trends with the potential to affect the market; as well as those already mentioned (most notably inflation), continuing supply chain issues and high energy costs could be a short-term drag on growth, as is the need to pay for support provided to the economy during the pandemic. However, bar an unanticipated exogenous shock or major geopolitical events, market participants are unlikely to become materially risk off. Instead, we expect most risk factors to play out in a manageable way, although it’s worth noting that for bond investors a slow deterioration of market conditions could ultimately cause greater losses than sudden volatility.

In the short term, with the pandemic clearly not over, there is a need to be vigilant on sectors vulnerable to increased measures. For example, we sold property holdings with a relatively large exposure to central and eastern Europe, as their retail component made them vulnerable to further lockdowns — something which is more likely in countries with low vaccination rates. However, unless there is a return to extended lockdowns elsewhere, many companies in potentially vulnerable sectors, such as hotel chains and airlines, have enough cash and liquidity to protect themselves.

With inflation a growing issue at least in the short-to-medium term, sectors that are unable to pass on increased input costs are best avoided. Examples are auto parts companies selling to original equipment manufacturers, as well as utilities companies in the UK who are hampered by the retail price cap.

We also remain vigilant on issuers in sectors which will be impacted by the transition to a low-carbon economy, focusing on companies with sustainable business models while ‘weeding out’ or engaging with those that do not. With the European Central Bank becoming increasingly vocal about including sustainable factors in its asset purchase programme, we expect to see a material increase in green and sustainability-linked bond issuance. While we welcome and will continue to review such issues, we will always analyse each company’s sustainability credentials as a whole, rather than in part. This is to ensure our investments remain consistent with our firm belief in the importance of sustainability to the global economy and as a driver of credit returns over the medium term.

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