Healthy premiums drive big day for primary markets
Let’s begin this note by being absolutely clear on one point: we expect the overall credit quality of the fixed income universe that we invest in, and in particular corporate credit, to deteriorate in the next year or two.
The deterioration had already begun at the beginning of 2022, and is getting gradually worse as the year progresses. However, there are two key questions we need to ask ourselves. One, are we being adequately compensated for this move? And two, more specifically, how much deterioration are we being compensated for relative to where this credit deterioration may end up, both in terms of ratings migration and default rates?
As we have mentioned many times on this blog in recent months, the starting point of this downturn for both consumers and corporates was extremely healthy. Consequently, a lot of bad news and fundamental economic deterioration can be absorbed without excessive pain. This is important, as usually when economies hit a downturn the starting point for consumers and corporates is a lot more stretched, which is what leads to a much higher default rate and more rapid ratings migration. From a markets perspective this is typically pretty painful, as valuations often begin at lofty levels when this happens, making the fall to reality a far worse experience. Fortunately, today valuations begin at levels where we see significant deterioration already being priced in.
Let’s start with default rates, which ended last year at almost record low levels across the globe. They have begun to tick up as one would expect, but only very modestly. At the end of October, the 12-month trailing default rate on US high yield bonds ticked up to 1.6%, an increase of just 1bp from a month earlier. In European high yield, the default rate increased by 5bp in the same period but remains very subdued at 0.4%. These figures are extremely low compared to historical averages of 3.2% and 1.7% for the US and Europe respectively, and is due to the solid starting points mentioned above. In our opinion, there is only one way this default rate is going in the next 12 months, and that is up, but our forecast of 3% default rates across European and US HY for 2023 remains well below peaks seen in previous recessionary cycles.
Readers might be wondering why the European rate is not going to be higher, given the majority view out there that the headwinds facing Europe are stronger than those facing the US. We completely concur with this stance, but US high yield is a riskier market on a fundamental basis; its average rating is B+ versus a European and UK average of BB-, and 11% of the US market is made up of CCC rated debt (the most vulnerable rating band, from which nearly all defaults historically arise) compared to less than 6% in Europe. In addition, companies in Europe and the rest of the world took advantage of rock-bottom interest rates over the past few years to extend and refinance their debt stacks. As a result, there isn’t a ‘maturity wall’ to be addressed this year or the next.
One leading indicator to a change in the default rate is ratings migration, which tends to turn markedly negative before the default rate picks up. Looking at this, and also looking at the percentage of the high yield universe that trades at distressed levels, does give us a good insight into credit quality changes and the future default rate. An arguably more logical picture emerges here, with US credit quality holding up materially better in 2022. Year-to-date there have been 1.25 upgrades per downgrade in the US, but the quarterly picture tells a different story. In Q1 there were over 2 upgrades per downgrade, according to Moody’s, but this has since deteriorated and in Q4 has inverted to 2 downgrades per upgrade, a significant move and one indicator of a tougher 2023 ahead of us.
In Europe there have been 1.5 downgrades per upgrade YTD, and in the most recent quarter that number is 3 downgrades per upgrade, clearly reflecting the greater challenges faced in Europe currently. This is also reflected in market pricing, and what we refer to as the ‘distressed’ universe of bonds, which we define as bonds whose credit spread is greater than 1000bp (10%) over the risk-free rate. In the US distressed bonds account for 8.6% of the high yield universe, while in Europe it is greater at 11.5%, but this cohort of credit risk has been relatively stable in its magnitude over recent months and compares to distressed ratios of 32% and 27% for the respective regions in March 2020. In terms of credit migration, we see this trend continuing and picking up as we go into 2023, with our projection being 3 downgrades per upgrade in Europe and 2.5 downgrades per upgrade in the US next year.
Putting all of this into context, this is a relatively mild credit deterioration projection for 2023, but with a high degree of conviction that deterioration is what we will experience in terms of fundamentals. What is priced into global credit markets is a very different story, with the outcome being priced in for Europe in particular looking far worse than our projection. At current spreads, a default rate of approximately 4% is priced into European high yield. Markets always fear and discount the unknown, and of course the future is notoriously hard to predict, but in the absence of additional major shocks we think the outlook for credit quality, despite obvious deterioration, is still benign, and we think investors are being very well compensated for taking this risk currently.
This is why we are now seeing ‘tourists’ starting to flock to credit markets, from private equity managers to hedge funds, who are scouring both traditional credit markets and structured credit markets, where it can be argued even more value is emerging, for cheap assets given the outlook that is gradually becoming more clear.