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By Robert Hopper, Vivek Bommi, Susan Hutman, Will Smith
Persistent inflation and prospects for a global economic slowdown loom large over the credit markets as we transition to 2023. Central banks around the world are attempting to beat back inflation and aggressive monetary tightening is working its way through the global financial markets, with additional rate hikes to come.
Fortunately for investors in investment-grade and high-yield bonds, credit metrics for many issuers are strong relative to their history following the global financial crisis, and they will enter any slowdown from a position of strength. But with the macro picture increasingly murky, investors will need to be selective.
Yields and Spreads Are Elevated
Following a protracted period of rate hikes that began in March 2022, both bond yields and yield spreads are at multi-year highs. To grasp just how much yields have jumped in over a year, consider that as recently as the third quarter of 2021, roughly half of European investment-grade corporates offered negative yields. Today, yields on US investment-grade corporates are at their highest levels since the global financial crisis, while on a currency-hedged basis, European investment-grade yields are even higher than equivalent US credits.
Higher yields are providing not only a significant yield advantage for fixed-income corporates over equity dividend payers, but they are also mitigating the downside of risk assets. In our view, generous credit spreads are also helping to compensate investors for the risk of recession.
Due to stubborn global inflation, our global economics team expects to see additional rate hikes early in 2023, although central banks are likely to slow the pace of monetary tightening in the face of slowing global economic growth. Until this process plays out and investors have more clarity about the direction of rates and corporate earnings, we expect yields—as well as market volatility—to remain elevated.
Company Fundamentals Are Sound
Fortunately, many companies enter 2023 on solid financial ground. Corporate fundamentals in the US and Europe are rebounding nicely from pandemic-related weakness, and commodity prices are retreating. Based on measures of profitability, as well as key credit metrics like leverage and debt-service coverage, most sectors appear solid relative to their ranges following the global financial crisis (Display). This contrasts with past economic slowdowns when corporate fundamentals have typically been much weaker.
US Credit Metrics Are Solid
Fundamental Metrics: Current vs. Range Since 2010
Strong fundamentals are due in part to fiscal prudence necessitated by the COVID-19 pandemic, which prompted many companies to manage their balance sheets conservatively. They also reflect that typically procyclical commodity companies have been benefitting from tight supply and high prices, using the related strong free cash flow to reduce debt to post-financial-crisis lows.
This kind of responsible stewardship will be especially important if global growth slows in 2023, as we expect it will. Companies with strong balance sheets and access to funding will be better positioned to weather the reduced demand and tighter credit conditions that typically accompany slower economic growth.
In addition, high-yield bond issuers should enjoy lower coupons over the coming year. That’s because there’s no approaching maturity wall that would force companies to issue debt at higher prevailing rates. In fact, only 20% of the high-yield market will mature by the end of 2025, with most maturities coming between 2026 and 2029. Even if yields remain elevated for the next four years, coupon rates shouldn’t return to pre-COVID levels north of 6% until early 2026.
Credit Stress Could Tick Upward, but Default Surge Not Likely
In the US, high-yield defaults peaked at 6.3% in October 2020, clearing out the weakest companies from the investable universe. In addition, a cohort of fallen angels (formerly investment-grade bonds) bolstered the BB portion of the high-yield universe to 50%, improving the overall quality of high-yield bonds.
Similarly, the European high-yield market has seen BBs increase to 63% of the total. The weight of BBs in both these markets has increased roughly 10 percentage points since the global financial crisis. As a result, both US and European high-yield markets in the aggregate are more creditworthy and should be better able to withstand market stress than in past downturns.
That’s good news for investors, as both European and US corporates are pricing in an uptick in stress over the coming year—but not a significant escalation in defaults. This is consistent with our expectation for only a modest increase in credit downgrades and defaults over the next 12–18 months. In the event the macro picture weakens more materially than expected, we could see greater stress, but given the starting point for corporate balance sheets and conservative financial policies, we would anticipate a less severe impact on corporate issuers in the aggregate.
Technicals Are Supportive of Credit
Technical factors appear to be supportive of credit. The European Central Bank (ECB) has concluded its myriad bond-buying programs, but the ECB continues to invest proceeds from investment-grade holdings. Meanwhile, eurozone credit issuance has fallen, keeping supply and demand relatively well-balanced.
In the US, high-yield technical factors go into 2023 with significant momentum. As investors returned to the market in droves late last year, high-yield mutual funds in November reported their largest monthly inflows since July 2020. Such high demand, which we believe will persist into 2023, should bode well for valuations. We expect that investment-grade corporate bonds will be next in line as elevated yields lure investors from the sidelines.
Given compelling yields, solid corporate fundamentals and potentially strong fund flows, we believe the coming year holds significant potential for corporate bond investors.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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