Bond yields are back, but with a difference. In a fugue, the theme repeats itself. If rising rates are a theme markets have seen before, this time the rising tempo of that theme may completely change the sound. Listen carefully, selectivity will be everything.  

Be careful what you wish for, you might get it.

The rise in central bank rates to combat inflation has sent shockwaves through bond markets, raising concerns about the risks of economic recession if they are too aggressive.

The combination of positive interest rates and historically high risk premiums in European credit offers attractive coupons to investors looking for a carry.

Never in its history has investment grade credit posted such negative returns, from -12.53% over the first 11 months of the year for the BoFa IG Euro Corporates Index.[1] 

 The tightening of monetary policies is the main factor behind this. It was impossible to transition from negative yields on German government bonds to 2% without losses.

Only 20% of the loss in value is attributable to credit risk. The normalisation of key rates should continue in 2023 but at a much less aggressive pace as inflation seems to have reached its peak. The main question will be the speed of its decline, excluding new exogenous shocks, particularly in Europe.

Risk premiums have soared from 1% at the beginning of January to 1.8% at the end of November for Euro investment grade credit and from 3.3% to 5% for Euro high yield credit[2]. These valuation levels exceed the historical averages of the last 10 years and imply default probabilities close to 8% for high yield, well above the historical 4.5% over that period.[3]

While early 2023 is likely to be complicated, with 4% yields on Euro Investment Grade today, we believe this asset class offers an interesting return in the current context.

Selectivity remains the order of the day

Fundamental analysis will remain key in 2023.

Credit ratios are likely to deteriorate noticeably in the coming months. Economic growth is slowing in regions around the world and the outlook for earnings growth is dimming.

The year looks difficult for the most indebted and cyclical companies. We expect more credit rating downgrades than upgrades in 2023.

Profit margins are expected to decline and leverage to increase. The most defensive profiles, or companies able to pass on price increases to their end customers, will be the winners.

Companies have benefited for many years from low financing rates and have taken advantage of this to extend the average maturity of their debt.

The increase in interest expense seems manageable for investment grade companies. Only 11% of total debt is due to be refinanced in 2023, at an average coupon of 4.20% compared to 1.90% in 2021.[4] 

On average, high-yield issuers do not have large short-term maturities. However, a prolonged restriction of the capital markets may be problematic for some companies. Although the average credit quality has improved significantly compared to the past, we expect the default rate to double to between 4% and 5% in 2023.

Caution on weakest links

A fugue returns preciselty to its pattern. The markets may not. The creditworthiness of issuers with the lowest ratings, from single-B to triple-C, is at risk.

These segments include many companies owned by private equity funds through leveraged buy-outs. The latter have used very high leverage, often at variable rates, to achieve their return targets in the context of low-cost funding. Now these companies face operating margin declines at the same time as they will suffer even greater pressure from significant increases in interest payments.

Some companies will suffer significant ratings downgrades, leading to underperformance or even default.

Finish the Fugue with a Flourish

We believe that 2023 offers real investment opportunities with attractive yields. We are also convinced that certain segments of the credit market will remain particularly vulnerable and that their probability of default is not yet fully reflected in credit spreads. Now more than ever, we believe it is essential to favour active management and have well designed credit and ESG analysts teams play moderato più moto.

[1] Data sources: Bloomberg, Candriam.

[2] Bloomberg, Candriam. For investment grade, data refers to ICE BofA Euro Corporate Index, for High Yield, data refers to ICE BofA Euroe High Yield index.

[3] S&P Capital IQ, 12-month trailing Specfulative Grade Default Rates.

[4] Bloomberg, Candriam.