Staying in credit

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After what proved to be something of a perfect storm for the asset class last year, what does 2023 have in store for credit? A more nuanced market, the aftermath of the pandemic and the current rising-rate environment, coupled with elevated volatility, are all likely to be key influences this year, according to Adam Whiteley, portfolio manager at Insight Investment.

A combination of rising government bond yields and widening credit spreads created a challenging time for credit investors over 2022, as absolute yields were driven back to levels not seen since before the global financial crisis (see Figure 1). 
 
At the start of 2023, and for the first time in years, credit markets potentially offer a way to achieve return objectives via income, possibly minimizing the drawdown risk inherent in equity markets, explains Whiteley. “In addition, from an asset allocation perspective, the traditional role of fixed income as a diversifying asset seems to have been restored, with the potential for meaningful returns from the asset class if central banks were to ease policy in a future downturn.”
Figure 1: Yields have returned to levels not seen since before the global financial crisis
Figure_1

Source: Bloomberg as of December 31, 2022. Global investment grade universe represented by ICE BAML Global Corporate Index (G0BC).

The right issues
Until there is greater confidence inflation is under control and the growth outlook has stabilized, the risk of further volatility persists. Although spreads have widened broadly, there are two significant underlying factors that, combined with more volatile conditions, have the potential to create notable dispersion in returns between individual issuers, according to Insight.
 
Whiteley adds: “The pandemic interrupted or accelerated several secular trends. As such, several sectors that could appear to be in decline or expansion may just be adjusting to the new post-pandemic world,” Whiteley says. “Separating those sectors which are seeing activity normalizing, and those experiencing more structural changes in demand will be key in the years ahead.”
 
Meanwhile, despite the rise in yields, many corporate issuers are insulated from the interest rate shock. Through the period of low rates, corporates gradually extended their maturity profiles, taking advantage of buoyant market conditions to lock in low funding costs. “As this debt gradually approaches maturity, funding costs are likely to creep upwards, but for many issuers it will be years before this has a meaningful impact,” explains Whiteley. “For those best able to pass rising costs onto their customers, the combination of high inflation and long maturity fixed-rate debt will potentially allow debts to be inflated away over time, effectively allowing some issuers to naturally deleverage.” 
 
Indeed, this could create significant potential to add value via sector and security selection. “Active managers should thrive in this environment; however, to fully benefit,” he tempers, “we believe it will be important to have the ability to invest globally, allowing the hunt for optimal positions across global markets.”
Spreading the risk

Although partially driven by wider spreads, a key factor in repricing has been a dramatic upward shift in government bond yields. This has increased the attractiveness of government bonds and may make some investors question the necessity of taking the additional risk inherent in credit investment. “We believe this risk is overstated, says Whiteley, “Spreads are sufficiently wide to remain attractive even when assuming a historically extreme level of defaults (see Figure 2). Indeed, although there is a degree of economic uncertainty as central banks seek to return inflation back to target, the outlook appears far more benign than markets are pricing in.”

Bond ratings reflect the rating entity’s evaluation of the issuer’s ability to pay interest and repay principal on the bond on a timely basis. Bonds rated BBB/Baa or higher are considered investment grade, while bonds rated BB/Ba or lower are considered speculative as to the timely payment of interest and principal. Credit ratings reflect only those assigned by Nationally Recognized Statistical Rating Organizations (NRSRO) that have rated fund holdings. Split-rated bonds, if any, are reported in the higher rating category.

Keeping active is key

“Although we believe attractive levels of income are now available in credit markets, and that spreads are overpricing the risks, we are cautious about predicting a rally in spreads in the short-term,” he warns. The uncertain outlook, and expectations of further volatility ahead, are likely to keep spreads elevated. At the same time, government bond yields are likely to remain under pressure until inflation is on a very clear downward path and far closer to central bank targets than it is today. 

Figure 2: Spreads remain attractive even when factoring in historically extreme levels of defaults
Figure_2

Source: Insight, Moody’s and Bloomberg as of December 31, 2022.

As we move into 2023 the outlook could, however, change considerably, according to Whiteley. “Markets are already pricing in significant rate hikes from global central banks, but a large part of the tightening cycle now lies behind us, with rates likely to peak by mid-2023 in many markets,” he says. With credit markets now offering a realistic way to generate returns without having to resort to higher risk assets, investor flows into credit markets should be supportive. “This should be further buoyed by demand from those seeking to hold fixed income as a way to diversify, with the potential for meaningful returns if yields decline in a future economic downturn,” Whiteley adds.

He continues: “Elevated levels of volatility, combined with structural changes in some sectors, is the perfect environment for active management, potentially allowing value to be added via sector and stock selection.”

Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.

1295120 Exp: 31 May 2023

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