INSIGHTS

Link para o artigo original: https://www.man.com/maninstitute/q3-2024-credit-outlook-selective-and-scrupulous

 

 

July 2024

 

 

Introduction

Stubborn inflation and higher-for-longer interest rates continue to dominate markets after a quarter which saw the Federal Reserve (Fed) announce that it expects to cut interest rates just once this year – a sharp contrast to the six cuts anticipated at the beginning of the year. Elsewhere, the European Central Bank (ECB) cut rates by 25bps but simultaneously raised its inflation outlook for 2024 and 2025 and chose not to outline its rate cutting path, suggesting that further cuts may be slow to come. Headlines in the UK initially looked promising with inflation easing to 2%, but digging a little deeper, services inflation remains elevated at above 5%, putting the Bank of England in a tricky spot. Against this backdrop, we remain on guard for global growth to slow and fundamentals in credit markets to deteriorate.

In addition, we have seen a rise in geopolitical risk over the last quarter, most recently in relation to the French elections. French President Emmanuel Macron’s call for a snap election caused jitters in the bond market, with French to German bund spreads widening out to 80bps and French corporate bonds underperforming in June. We have seen some recovery in July, but the shock result of the second round of legislative elections has demonstrated the political backdrop is primed for instability and potential shocks.

We believe that opportunities within credit persist in this environment, but that it lends itself to discriminate investors who have the flexibility to dive into the detail and to be selective.

A new yield environment

There has been a lot of commentary, including from ourselves, in recent years about whether bonds are back after a challenging 2021 and 2022. What the numbers clearly show is that investors are currently being offered additional yields for the higher interest rate environment. Indeed, current yields are at appealing percentiles relative to history, implying strong total return potential, as well as protection against wider spreads.

In Figure 1, we show the yield-to-worst, a measure of the lowest possible yield an investor can expect to receive on a bond without the issuer defaulting, across European, US, leveraged loans and EM credit on a percentile basis since 1998.

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Yields clearly imply an attractive forward total return for investors. Looking at the high yield bond market in particular, investors have historically received attractive total returns on a one-year forward basis when investing at these levels, even including defaults.

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Credit yields not only look attractive relative to history but also relative to other asset classes, especially equities. In 2023, the average credit rating of companies in the S&P 500 Index was BBB+. Yet, as shown in Figure 3, the earnings yield of the S&P 500 equities index today is far below the yield on BBB US corporate bonds. Indeed, it is currently at the lowest level it has been since the 2008 Global Financial Crisis (GFC). In short, equity investors are not being as well compensated for their place at the bottom of the capital structure, largely owing to the stock market rally which began at the end of 2022. It is also worth noting that previous instances when the yield on BBB US corporate bonds has exceeded that of the S&P 500 Index have preceded a large sell-off in equities.

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Attractive yields hide more challenging level of credit spreads

What today’s attractive yields mask, however, is the more challenging level of credit spreads within markets. Investors must thus look not only at the overall yield, but also at the proportion coming from credit spreads. Taking this perspective, credit at an index level looks more expensive. In high yield, for example, approximately 60% of the market trades at spreads below 300 basis points – not enough to compensate investors throughout the cycle. Furthermore, the US market continues to be priced for perfection with US investment grade (IG) spreads at their 18.7^th percentile and US HY at their 12^th percentile and the average price of leverage loans has pushed above 96.¹

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Cracks opening to present select opportunities

In light of this, we are certainly not advocating buying the whole market. Last quarter, we highlighted that the first small cracks were beginning to appear, with interest coverage ratios (companies’ cushion to pay down their outstanding debts) trending downwards. We also saw signs that issuers were buckling under the pressure of higher coupons in leverage loans and high yield bonds. We have seen a continuation of this trend over the last quarter and we also saw AAA-rated commercial mortgage-backed securities (CMBS) experience losses for the first time since the GFC.

In addition, we are seeing an increase in the level of dispersion in lower quality credit. Dispersion is positive in our view as it leads to much greater discernment between business models. We expect this dispersion only to increase as higher rates continue to work their way through the refinancing channel and impact on the cash flows of businesses. Figure 5 captures the spread dispersion in high yield credit by showing the inter-decile range divided by the median index constituents. In contrast, dispersion remains relatively low in IG, which calls for a more defensive and focused approach on attractive sectors.

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Opportunities are skewed to Europe…

We have for some time expressed our preference for opportunities in Europe given the more elevated level of spreads relative to the US. We have seen Europe catch up to the US – although more recently the French elections led to some widening – but some premium remains and we believe Europe continues to offer an intriguing opportunity for investors.

The trouble brewing at several large capital structures against a higher-for-longer backdrop means credit investors need to beware of creditor unfriendly tactics such as dropdowns (moving assets, typically from a parent company, into a subsidiary or affiliated entity, often to optimise financial structures), which can reduce recovery rates. Additionally, creditor-on-creditor-violence (actions that harm or disadvantage other creditors, typically during financial restructuring or bankruptcy proceedings) as secured and unsecured creditors grapple for better positioning is likely to play a more prominent role in Europe. We prefer small- and medium-size capital structures, where we have more ability to influence the eventual outcomes of a structuring through leading credit committees.

In high yield, low growth has been priced into the lower segments of the market in Europe, but not in the US, creating a valuation discrepancy, as shown in Figure 6. This offers a good starting point for finding value in select businesses which have been unfairly tarred with the same brush, perhaps because of the sector in which they appear. Interested readers can learn more about the opportunities we see within European financials, in particular, in our recent paper.

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…while in private credit, the opposite applies

While we favour opportunities in Europe over the US in public credit markets, the opposite holds true for private credit, a topic our colleagues at Man Varagon explore in greater detail in a recent paper. Although private credit is similar in structure and pricing across the two geographies, the US direct lending market is larger and better developed, with more experienced players.

This is largely owing to the secular shift towards non-bank lenders we have seen in the US since the GFC as a result of bank retrenchment, a trend which we expect to continue. In contrast, regional and local bank participation in Europe remains strong. Europe has consequently taken a smaller share from traditional lenders and the European private credit market is less mature.

Q3 2024 Outlook

At Man Group, we have one overriding principle: we have no house view. As such, portfolio managers are free to execute their strategies as they see fit within pre-agreed risk limits. Keeping that in mind, the outlooks below are from the different credit teams.

Global Investment Grade:

As described earlier, yields across public fixed income appear attractive relative to history. However, spreads remain at or close to bottom quartile valuations.

While dispersion has fallen across sectors, we continue to identify opportunities across the financial sector where the margin of safety more than compensates us for lending money. This part of the market offers a broad array of potential investments with different business models, creating more diversification than implied by sector classifications. Financial services, for example, encompasses banks, non-bank lenders, asset managers, brokerages, exchanges, commodity traders, business development companies and insurance companies, offering a wide array of security selection opportunities.

Outside of financials, we see idiosyncratic opportunities within European real estate, despite this year’s rally. We retain a European bias versus North America while flat yield curves push us to favour shorter-dated securities.

Global High Yield:

While spreads are tight, the level of yield available in the market creates a strong breakeven cushion for investors. Overall fundamentals remain solid, with leverage falling to levels below those witnessed before the onset of Covid-19. High yield bond default rates marginally fell over the first half of the year while leverage loans saw a minor increase.

Several issuers in the telecommunications, media and real estate sectors continue to trade at distressed levels. We have selectively added exposure to individual US media companies which may benefit from short-term revenue growth ahead of November’s election. Elsewhere, our activity has been focused on the financials sector, particularly in geographies such as Eastern Europe. We continue to avoid the more cyclical sectors of the market, such as automotives, where we do not believe that we are being sufficiently compensated to add risk.

Emerging Market Debt:

Macro themes, namely uneven growth, sticky inflation, and rising political risks, continue to dominate EM. While Fed policy drives the near-term rate narrative, US election concerns are rising, specifically around US fiscal health and Treasury supply, as neither party addresses the deficit.

IG sovereign valuations seem somewhat attractive but face headwinds from rate volatility and challenges in China, Middle Eastern oil countries, and Eastern European nations affected by euro area political volatility. Some BBB countries risk falling to HY, justifying the current premium. Most EM distressed spreads have normalised, reducing opportunities. Bottom-up factors will drive returns in this segment, though limited summer liquidity can cause sharp swings in valuations. We focus on countries with solid fundamentals, external market access, or geopolitical importance and wait for valuation dispersion to broaden out further when spreads widen, increasing directional and relative value opportunities in the hard currency credit space.

In local currency markets, EM currencies face pressure from USD strength and shrinking rate differentials, leading to bond outflows. Politics and election outcomes have also become a significant influence on FX and rates differentiation. Rising trade frictions, driven by China’s manufacturing overcapacity and new tariffs from the US and EU, add strain. Potential heavy tariffs, highlighted by former President Trump’s campaign, could further pressure EM FX, especially in countries with large US trade surpluses like China, Mexico, Malaysia and Thailand. Other EM countries integrated into global supply chains would also be indirectly affected. However, supportive FX valuations have helped improve EM current account balances from deficit to neutral. Increased valuation dispersion in EM FX and varied country fundamentals should create more relative value opportunities once the dust settles.

The Fed remains a constraint for EM local rates, where margins of safety are thin and significant disinflation progress is behind us. Disinflation has slowed, relying on decelerating services inflation. Tight labour markets and robust wage growth have kept services inflation elevated and core inflation above target in Latin America and Emerging Europe. With disinflation stalling, EM easing has lost momentum and is increasingly dependent on the Fed and USD, potentially delaying EM duration gains.

Lastly, positioning analysis indicates the market is more crowded than it appears, considering dedicated EM fund flows alone. This may fuel volatility given the seasonal lower liquidity ahead.

Emerging Market Corporate Bonds:

EM corporates continue to be at the coal face of the tug of war between yields and spreads. We think that index spreads could continue to be supported by the positive macro backdrop and yield-focused investors. However, the continued push lower in spreads makes us much more selective and we remain very cautious particularly on investment grade issuers and areas such as the Middle East and portions of Asia. Year-to-date issuance of $209 billion is up 50% from 2023, but still around the median when looking at issuance over the past decade. Positive gross issuance was not able to counteract robust cash flows and net financing turned negative to -$35 billion in the second quarter². We continue to maintain a barbell approach to the market, preferring shorter duration carry and refinancing trades given the rebound in local currency funding markets. We also see selective opportunities in industrials and consumer-related sectors across Latin America and Asia.

Convertible Bonds:

Primary market activity remained resilient in the second quarter with a total of $35 billion pricing globally, taking issuance for the first half to $60 billion (up from $39 billion in the first half of 2023)³. Volumes continue to be supported by a combination of higher-for-longer rates and the large wall of pandemic-era debt that still needs to be refinanced. Indeed, nearly 40% of primary market proceeds year-to-date have been applied to repaying existing debt, with a large portion of that coming from so-called “crossover” issuers looking to repay straight debt with lower coupon convertible bonds. Having said that, tight credit spreads in both the HY and IG spaces have somewhat hampered primary volumes from crossover issuers relative to expectations. This has pushed up the average credit quality of issuers in the asset class with nearly a third of new supply coming with an IG rating – the highest in more than a decade. Looking ahead to the rest of the year, we expect the conditions that have supported primary activity year-to-date to continue.

In terms of performance, convertibles have lagged global equities year-to-date since they lack exposure to mega-cap names which have led the very narrow rally. On top, the best performing sectors year-to-date have only a small relative weighting in the asset class. Having said that, convertibles have been outperforming their underlying equities this year and have also been capturing more upside than downside, highlighting their convexity benefits.

For the rest of the year, we are optimistic that the recent underperformance of small- and mid-cap stocks can reverse, supporting convertible bond returns. In particular, these stocks will benefit from any increase in rate cut expectations since they have been punished the most by the higher for longer environment. Should rate cut timing expectations continue moving in the right direction, we believe convertible bonds will continue to at least outperform their underlying shares. We believe this creates a compelling opportunity for convertible bond investors in the second half of the year.

US Residential Credit:

For US residential credit investors, the first half of 2024 continued to demonstrate robust housing fundamentals and compelling opportunities. The underlying housing market has successfully navigated elevated rates, coming out of a period when other asset classes experienced sharp declines in both valuations and investor confidence. This new era is unlike the residential credit dislocation witnessed throughout the last two years, where opportunistic investors were able to take advantage of the rapid rise in interest rates, higher bond yields and home price appreciation. Today, with elevated rates, higher home prices, and increased investor appetite, we’ve seen AAA securitisation pricing and direct senior origination spreads tighten by 50-100 bps. We feel that spread compression is mainly a result of investors recognising distinctively strong market fundamentals; and investors and sponsors anticipating rate cuts at the end of the year.

For equity investors, this lowered cost of financing is a compelling opportunity to take on new projects coming out of a period of sustained negative leverage and is charging demand for financing within the sector. Banks continue to stay sidelined as they work through troubled assets/capital requirements primarily from their non-residential commercial real estate (CRE) loans, allowing for private credit institutions to step in to bridge the demand gap.

Our approach to US residential credit remains active and capitalises on healthy underlying markets, benefiting from structural protections to insulate investors during times of macroeconomic uncertainty. We expect to see this current market dynamic persist, with compelling opportunities for investors seeking income-driven returns from low-volatility, diversified credits backed by liquid residential collateral.

Leveraged Loans:

Leveraged loan activity remains strong in 2024 with prices in the secondary market rallying to two-year highs on the back of increasing investor demand. An increased risk appetite has led to more opportunistic repricings and issuance while spreads on newly issued loans have fallen to the lowest levels we have seen in a few years. Issuance set a new record in Q2, totalling $405 billion with a significant uptick in issuance in lower rated credits, which have been frozen out of the market over the last couple of years. Total issuance of $736 billion year-to-date is the highest level since the GFC and well above the $200 billion in transactions over 2022 and 2023⁴.

Like other areas of credit, the net issuance picture remains less buoyant, with the total amount of new loans equating to only 13% of all activity. Flows into the asset class continue to remain robust across both mutual funds and exchange traded funds. This demand has led to the average bid of the index to move to a 2-year high of 96.99 with more than 65% of performing loans priced at par or higher⁵.

We continue to take a relatively cautious view on loans as despite the positive technicals and attractive carry, the high average prices provide limited additional upside for investors in comparison to what might be achieved in the high yield market. We also believe that fundamentals continue to deteriorate and we prefer opportunities in high yield over loans.

Credit Risk Sharing (CRS):

While issuance from North American banks has been somewhat muted in the first half of the year (just a few one-off transactions), European banks remain active, with many banks reaching record issuance levels. We expect transaction volume to grow during the second half of the year, with over $8 billion (tranche size) of transactions on our radar, including a significant increase from North American banks.

Over the past several months there has been a notable increase in demand for risk transfer investments, fueled by both traditional significant risk transfer (SRT) investors and large private credit/structured credit funds. This spike in demand has led to spread compression of 200+ bps from the widest levels in 2022. We remain prudent on capital deployment and as such, we have seen our “hit rate” decrease from the prior two years. We expect the demand for fully disclosed large corporate transactions will remain and we see relative value in other areas, such as strategic large-size bilateral transactions, leverage finance, and non-disclosed corporates.

1. Source: Bloomberg, ICE BofA and Pitchbook.
2. Source: JP Morgan.
3. Source: BofA.
4. Source: Pitchbook.
5. Source: Pitchbook.