What is the current outlook for investors in today’s credit market?
Interest rates have been declining for a long time since the 1980s. In the aftermath of the Global Financial Crisis (GFC), interest rates hovered near zero as central banks introduced quantitative easing (QE) to provide liquidity to markets. These monetary policies, among other things, boosted valuations of most assets, including private and public debt.
This trend ended in 2022 when the central bank began raising interest rates and tightening credit terms to curb inflation. Investors today must navigate this transition successfully. In terms of economic representation, to quote Thomas Piketty, we have moved from a world where r > g to a world where i > g, from a world where real returns exceed economic growth to a world where nominal interest rates exceed. . outpacing the economic growth rate.
this has Significant impact For borrowers whose earnings are expected to grow slower than the interest accumulated on the borrowed funds. As our parents might say, this will ‘end in tears’.
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Simply put, many businesses and investments are untested. Since 2009, nominal growth has outpaced nominal growth, except for a brief period in early 2020. Warren Buffett’s famous words“You’ll only know who’s swimming naked when the tide goes out.” Well, the tide is leaving, with default rates and bad exchanges rising at the same time as companies refinance at higher interest rates. There is likely to be.
Businesses feel pinched when revenue growth is slower than their cost of financing, especially over a long period of time. This, combined with the large amount of fixed-rate U.S. corporate fixed-rate debt maturing in the next few years and the disrespectful treatment of banks and other traditional financial institutions, has left many firms vulnerable. will fall into a bad state. Some companies carry forward debt early, even at high interest rates, to avoid the possibility of not being able to pay it all later. High-yield borrower costs have hovered near 9%. For investors, the focus of risk has shifted from rising cost of capital to refinancing.
Year-to-date, the total number of corporate bankruptcies in the United States is at its highest level since 2010. The pace of defaults is expected to continue, if not increase, in 2023 and 2024 as the impact of rising interest rates, slowing economic growth and inflation has lagged. This is not “business as usual”.
Investor risk appetite has also changed. Investors may have felt they had to embark on more of the risk continuum to capture yield, but with risk-free interest rates rising, investors have less of a need to do so. Disruptions in the U.S. regional banking sector, including the failures of Silicon Valley Bank and Signature Bank in March and First Republic in May, have cast a shadow over lending.a Recent reports A survey of US economic activity showed slowing job growth and a worsening near-term economic outlook.
What about the public and private credit asset allocation then? Rising interest rates drove bond prices down. Despite the continued love of private bonds, there is an overlooked and growing opportunity in public bond markets that appears to be mispriced relative to risk and return. . In 2020 and 2021, public and private debt have been priced at par (or higher) with private debt offering a liquidity premium in the form of a fat coupon. Things are different today, and Edge has moved to the public market. There are several reasons for this.
In public bond markets:
- Prices are determined on the open market and adjusted as market conditions change.
- Greater price transparency. This creates more price volatility and more opportunities to acquire assets below par to increase your margin of safety.
- High liquidity makes it easier to exit positions when the risk/reward balance shifts or when capital is expected to be deployed.
- Companies that issue bonds have proven their business model in the market.
- The public markets are becoming increasingly diversified in bonds.
- In a rising interest rate environment, public debt provided more correction than private debt.
In any economic cycle, some companies with strong growth carry some level of debt. For example, since 2015 the energy sector has been under severe stress, while other sectors such as hospitality have not. In 2020, during the peak of COVID-19, hotels, movie theaters and car rental services struggled, but bakeries did well. At some point, prices in the stressed sector fell far enough that investors could compensate for the risks. Selective investors are likely to find companies with quality assets and strong competitive advantages. Public bonds can be subject to mispricing due to the occasional price volatility.
Over the past four default cycles, low-grade high yield bonds have averaged drawdowns of around 30%, with average recoveries over the next two years of around 80%. With the high-yield bond market down about 18% in 2022, investors are starting to see an eventual recovery in low-quality credit.
Investors looking to diversify their portfolios and take advantage of valuation differentials between public and private bonds should consider allocating to public credit. Among the various SMEs, there are attractive risk and reward propositions. Due to their size, these companies are severely short of capital and investors face less competition from other capital providers. In addition, credit conditions remain tight and refinancing costs are rising, so more quality companies will need to raise capital.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect those of the CFA Institute or the author’s employer.
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