27. Nov. 2023
Yields across most parts of the global credit market are at their highest in over a decade. This bodes well for the return outlook; history has shown us that the yield at which investors buy credit assets is the best predictor of what they will earn over the subsequent years. Elevated yields should also give credit investors a really useful cushion to absorb a potential increase in volatility in the year ahead.
If we look at how the credit market has evolved through the lens of credit spreads – the amount of compensation investors get over and above government bond yields – there’s been a pendulum swing. This is creating a compelling backdrop for active investors.
The bond bear market in 2022 was characterised by a widespread, correlated sell-off, with the reaction to rising government bond yields sweeping across all areas of the credit market to result in large negative returns across the credit universe. In contrast, in 2023, the level of dispersion shot up, with substantial variability in the performance of individual credit markets. This reflects a shift in focus from the macro to the micro level, with closer scrutiny of individual companies’ (differing) ability to navigate a higher-rates world resulting in a huge variation in credit spreads. This can be seen both within the different credit market segments and between them. The upshot is that investors will need to be selective – now is not the time to follow an index; this is an environment that is ripe for dynamic and unconstrained investing based on bottom-up views.
The prospect of weaker economic growth and an environment of higher rates will test companies and we expect default rates to return to – and then exceed – long-term averages of around 3%. However, given how healthy corporate balance sheets are today relative to previous cycles, absent an unexpectedly deep recession, we don’t expect default rates to hit traditional cyclical peaks.
But it will still be vital to distinguish between winners and losers, and some parts of the market are looking quite exposed. For example, investors in the high-yield debt market are not sufficiently compensated for default risk, in our view, as we outlined here.
Company fundamentals have been incredibly resilient in the face of higher yields, especially in the US. This is largely thanks to the great job many companies have done over the past decade in locking in incredibly low funding costs.
While fundamentals will likely soften over the next 12-24 months, the starting point in terms of interest coverage (record highs) or leverage (record lows) puts the credit market on solid foundations. But selectivity is the most important factor from here, as noted above.
Not all companies locked in low rates when they were available and it is these that are looking vulnerable. We see this in lower-quality parts of the loan market, which have more floating-rate debt issuance in their capital structures; there, downgrades have been outpacing upgrades by some margin. But even in the loan market, we find pockets of value, particularly in the higher-quality, shorter-maturity parts of the market.
We expect the high-dispersion, high-differentiation situation to continue in credit markets. This is giving rise to areas of opportunity across a variety of credit market segments. We particularly like the structured credit market, with investors being compensated very generously for credit risk. Elsewhere, in the banking sector, we are seeing a huge amount of value: in the more subordinated parts of this market, such as bank capital, valuations look compelling relative to lower-rated high-yield markets; and senior debt for even the large national champion banks look very compelling relative to the broader investment-grade bond market.
Historically high yields seen across the asset class should ensure that demand remains strong, in aggregate. In 2023, investors were drawn to investment-grade debt and government bonds – the higher-quality parts of the asset class. We expect demand to widen across the broader credit market opportunity set in 2024. Very rarely do we see credit asset classes pay yields that are higher than the dividend yield many equity products currently provide, in effect making credit more attractive from a risk-return perspective. Once investors become more comfortable with the direction of interest rates, we expect them to start shifting their allocations accordingly.
General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise. Loans: The specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Many loans are not actively traded, which may impair the ability of the Portfolio to realise full value in the event of the need to liquidate such assets. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss.