Deep dive into credit markets

Two years ago, bond yields and credit spreads experienced significant upward movements; and since then, corporate debt markets have enjoyed a very positive directional move with credit spreads tightening from more than 600 basis points (bps) to less than 350 bps¹, adding to the compounding effect of carry, with the total returns of credit indices ranging from 3% to 10%² on an annualized basis since June 2022.

Where does this leave us today? The level of risk premium across credit segments has returned closer to 2021 levels; so not particularly generous at index levels. Yet conversely and thankfully bond yields are at much higher levels, meaning that the case for credit still rests on carry. Historically, it is the combination of low bond yields and low credit spreads that have been disadvantageous for the asset class but the current higher-yield environment means that credit spreads can act as both a kicker for investor returns and a cushion for volatility; with potential concerns out there being that generally credit spreads reflect a perfect landing of the economy and that incrementally negative datapoints create an asymmetric risk profile to the downside for the asset class.

¹For EUR High Yield Credit indices (Bloomberg code: HE00) as of June 2024.

²For respectively EUR credit investment grade and EUR credit high yield markets.

The economic outlook is rather supportive: we see continued acceleration in real wages in the UK and the Euro area and a decelerating yet resilient US economic growth environment, with capital expenditure cushioning the impact of consumer fatigue as well as prospects of a synchronized upturn of the manufacturing cycle. Such an economic outlook combined with projections of lower policy rates are pointing at a relatively benevolent environment over defaults and impairments for the corporate world.

This is especially true, as during this cycle the corporate world has been relatively frugal leverage-wise and a great number of companies have made the most of the “low rates, low spreads” environment in the direct aftermath of the Covid 19 pandemic, and have been hence relatively unscathed by the increase in the cost of financing. Moreover, due to the upcoming monetary easing cycle, the shorter the maturity of the underlying assets the quicker the benefits of lower policy rates will be felt. As money market funds will lose some of their attractiveness even more, flows coming into credit markets should provide additional support to the asset class.

Therefore, from an asset quality perspective the central scenario is that of a relatively supportive and benign top-down environment meaning that credit spreads could remain relatively tight for an extended period.

As the saying goes, the “worst of loans are made in the best of times”. But “time passes, as always” and higher yields indulge patience, allowing investors to wait for opportunities to show up.

The top-down environment is supportive for credit markets and yet, while expected to abate somewhat over the coming quarters, the environment in terms of higher cost of capital has drastically changed.

And a theoretical yet concrete and realistic example can serve the purpose: Let’s consider an ambitious business model where the contemplated corporate has a leverage to EBITDA of about 5x to 6x (which can be found these days in Telecoms). In yesterday’s world such a company would be refinancing every 2 years at ~5% (i.e. the average cost of “single B” rated bonds over the past 10 years); meaning that 30% of EBITDA would be devoted to the servicing of the debt, a demanding yet viable level which appears tenable even in a context of a sliding EBITDA and reasonable reinvestments. Fast forward to today’s world and the refinancing cost has heightened to ~10%; the corollary of which is that the same company is devoting two third of its earnings to debt servicing. A bump on the road or unforeseen complication then becomes a real issue. Even more so as the increase in “risk free” short term money market instruments implies that the strive for yield has led to lesser abundance of available capital.

It's not all bad news though. The positive flip side of such a new conundrum is that dispersion remains elevated. In such an environment, qualified credit managers can find value in corporate credit issuers with decent assets and yet a poorly structured balance sheet. As well as within sectors which are, for the wrong reasons, eluded by other (mostly benchmarked) credit markets actors.

In conclusion, dispersion allows for alpha generation and for the building of an attractive yielding portfolio in combination with a command of its risk metrics. i.e. dispersion means that an active bond picker can build a portfolio with a high aggregate yield while having an aggregate cross-over or investment grade rating. A valuable feature as it wards off overly relying on carry to “carry” high yield markets.

Defaults rates have been grinding higher at an annual pace of 4% and yet credit market returns are up by 20% over the past two years. As we are entering a period where credit markets are expected to be less forgiving, avoiding potentially problematic names is increasingly crucial.

As another saying goes “economic cycles don’t die of old age”, well good businesses rarely die of higher rates but zombie companies may, given concerns over the viability of their business models and associated excess leverage. Therefore, it is of upmost importance for credit investors to fully appreciate and understand the business models and risks to which individual credit issuers are exposed to. This enables investors to make sure both risks are well remunerated and that those businesses can make it through an entire economic cycle.

Beyond the necessary and extensive work of issue and issuer selection, one potential concern for investors is how one can seek a smoother ride ahead in credit markets should sentiment turn south?

Clearly, the level of yields embedded in a portfolio allows to digest some volatility. With a Yield To Worst of 6%, it would take two weeks of carry to make up for the negative impact of a +5 bps upward move in bond yields; back in 2021 it would have taken two months to do so!

Short term to intermediate duration could also help. Indeed the Federal Reserve’s (Fed) reaction function is asymmetric: if inflation grinds higher, the Fed Chair, Mr Powell will hold interest rates where they are. And if growth and employment were to deteriorate sharply, he will slash policy rates. As such the possibility of a ‘Fed Put’ is back – even more so as expectations of cuts over the coming year(s) is low – which should provide some cushioning for the rates components, inherent to a credit investment.

And finally, with the levels of credit spreads embedded in synthetic indices (around 300 bps for European High Yield and flirting with 50 bps for Investment Grade), along with the low level of volatility for those same markets, allow for the building of protection in a credit portfolio at a reasonable cost. Provided it stays at current levels, the cost of carry for holding such instruments is around 25 bps per month, and the payout could prove material should a risk-off environment materialise. Periods where credit spreads pick up by 50 to 100 bps over a month aren’t that uncommon, and such an outcome would lead to a price action of +2.3% to +4.5% should it occur.