Nov 23, 2021
Hear from Head of Alternative Credit Jeff Boswell on how to navigate the altered backdrop.
Over the past year we’ve seen the phenomenon of ‘a rising tide lifting all boats’ in global credit markets, with spreads and yields approaching historically tight levels in most markets.
This means that at the aggregate level credit market valuations appear expensive and some of these markets are looking particularly vulnerable to a price correction. However, look beneath the surface and you find significant differentiation, with some markets still offering compelling valuations for active investors who are able to cast a wide net. US high yield is a good example of where we think both the highest and lowest quality parts of the market are particularly expensive, masking attractively valued opportunities among the middle-rated categories.
Offsetting the theme of generically tight valuations is a more constructive outlook for company fundamentals. Default rates – a vital area of concern of credit investors – are exceptionally low across both European and US markets as the global growth backdrop improves. This favourable fundamental outlook arguably justifies tight valuations and favours credit investors who can find those areas of the market that are still attractive from a valuation perspective.
Returning to the theme of a rising tide lifting all boats and considering what challenges 2022 might hold, credit investors should prepare for a shift in conditions and increasing dispersion in the performance of companies. While all companies benefited from the unprecedented support measures from policymakers in 2021, as that tide of support recedes and new challenges (inflation/supply chain issues/labour shortages) emerge, vulnerabilities will be laid bare. This will ultimately reveal winners and losers within the corporate landscape.
Against this backdrop, credit investors will need to be more selective in their approach, aiming to avoid companies that are most vulnerable and to seek out those with resilience. Investors should also expect increased volatility against this backdrop. As we see a moderation in growth momentum as markets adjust to a new economic normal, investors should not be tempted to buy into credit stories that are heavily reliant on a continued unrealistic economic trajectory, or that are not paying them sufficiently for the associated risk.
Another continuing theme will be the ‘greening’ of credit markets, already demonstrated by the surging issuance of green and sustainability-linked bonds during 2021. Investors will need an increasingly wide lens and new analytical approaches to navigate opportunities arising in that field and, more broadly, to assess ESG risks and opportunities which are increasingly being priced into markets.
Given the balance between the market valuation picture and the fundamental strength described above, we would describe our current positioning as cautiously constructive. While the fundamental backdrop is strong, valuations in credit markets limit the potential for further spread compression-driven gains. Our focus is on earning attractive carry for investors in the parts of the market that still offer value, while the potential for increased dispersion leads us to tilt towards some of the more defensive areas of the market.
2021 was about dynamically allocating across global credit markets to capture the rally that permeated across markets as economies reopened, and seeking out companies where we saw strong scope for improvement. 2022 will be more about focusing on the more defensive areas of the market that offer the right balance of yield and downside protection.
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