While credit markets have sold off, they are not signaling inflation. Robeco's fixed income client portfolio manager for APAC David Hawa discusses opportunities.
The recent sell-off in equity markets has spilled over into the credit markets but it has been quite well behaved. What is the next test credit markets will face if cooling economic growth starts to impact corporate earnings?
Credit spreads will widen out further. As markets start to price in a higher probability of a recession, credit spreads will start to reflect credit default. The widening in spreads had been linked to liquidity premia rather than credit default premia.
However, we are beginning to witness this as spreads have increased in these last few weeks.
What will be the consequences of quickly rising rates given years of low borrowing costs? How do you see the corporate bond market playing out?
The cost of funding will increase. However, when analyzing the interest rate coverage ratio for the corporates, most of these are at a very healthy level. This indicates that corporates are not concerned with current rate levels. The reason for this is that most companies have secured their funding on a long-term basis at very low interest rates. However, this will change when these loans come to maturity, and new loans will need to be taken out at higher interest rates. Interest rate coverage ratios will deteriorate. So it is not a concern this year, but it could become one if we remain in a high-rate environment for a prolonged period.
As an investor, spread premia over government bonds is an indicator of how much is priced in terms of risk. So even though we could see a slowdown in the economy and an environment of higher rates, if spreads increase and the analysis undertaken indicates that an investor is being rewarded for this risk, it will be time to have an overweight exposure to this asset class.
Purchasing programs from central banks have to a certain extent, distorted bond markets.
Both yield levels for government bonds and spread levels for corporate bonds were determined by the number of purchases undertaken by central banks and were maintained at artificially low levels. This increase in demand was not driven by fundamental factors but purely by asset-buying programs. This distortion will stop, and markets should revert to more traditional fundamental analysis.
This distortion has also implied that weak companies, especially those with highly leveraged balance sheets, such as the weaker part of the High Yield market (CCC-rated bonds) were able to survive in such an environment. A slowdown in economic activity combined with higher rates should clean out these weaker companies.
We have learned to be humble when it comes to predicting inflation. We all witnessed last year's debate on whether inflation was going through a temporary increase brought about by supply chain disruptions or if this was truly a structural change. The US Fed has been accused of acting too slow, and financial markets are pricing aggressive monetary policies to try and control higher prices.
Could there be a credit event?
We do not foresee a credit event. However, dispersion within the credit market had decreased tremendously. When comparing spreads in the weakest part of the High Yield market, notably those with a CCC rating, and comparing these to BB or BBB rated companies, spread differences had decreased. This was driven by investor demand and the search for yield. Dispersion will increase once again as investors will shy away from highly leveraged corporates and this difference will normalize once again to reflect the higher risk of investing in weaker credits.
Assessing where we are on the credit cycle is key in determining the risk level in a credit portfolio.
Credit markets are not efficient and tend to overshoot both in a positive or negative environment.
An active manager can identify these inefficiencies and based on a research-driven approach can apply a contrarian approach.
Are ESG-focused credit investors taking more action in their portfolio allocations? If so, how?
ESG analysis of a specific issuer would imply digging deeper into the research analysis. This would mean knowing the company better and going one step further in the fundamental analysis. Normally, ESG analysis highlights the downside risk of a company rather than highlighting the upside potential. Good governance will not necessarily mean that the price of a bond would increase. However, weak governance could highlight a potential weakness in a company the price of that bond could decrease.
So, in terms of action, investors can now determine the level of sustainability they would like to have in their portfolio. ESG integration in the investment process or defining the investable universe by excluding certain companies that are not at the required level in terms of the investor's sustainable objectives or goals.
Credit research analysis always needs to be granular and treated on a case-by-case basis. What applies to one corporate will not necessarily apply to another corporate. A specific corporate could have a weak ESG profile. What is important is identifying this weakness, assessing it, and evaluating how much spread compensation is required to compensate for this risk.