Global Credit Outlook: Cautious on Turbulence & Technicals
1) Rate volatility was a major driver of global bond markets in 2022. European investment grade bond (IG) spreads reached 10-year highs! What’s your view on current spread levels and where might they go from here?
We believe recent spread tightening will prove to be a false relief rally. The recent positive momentum encouraged market participants to deploy cash balances and invest inflows heading into year-end, with a tilt toward BBB-rated securities and new issues. Additionally, with poor liquidity in euro IG, inflows have driven spreads tighter than fundamentals would otherwise imply.
Current valuations appear attractive historically, especially when considering all-in yields. However, we have a cautious outlook and expect spread widening from current levels. We expect rates to remain volatile and economic weakness to drive fundamental credit deterioration. Combined, we believe these factors could lead to a turbulent 2023 in credit markets.
2) Let’s talk more about fundamentals. Why do you think they’ll deteriorate in 2023?
So far, fundamentals have remained healthy, with EBITDA up slightly across most sectors, net leverage flat and interest coverage near record levels. However, we see reasons to be cautious as we turn the page on the calendar. We expect monetary policy to exert pressure on the growth outlook in 2023, which could squeeze corporate earnings and bring a recession into sight. Additionally, we fear some of the recent earnings resilience is the result of companies offloading built-up inventory backlogs that aren’t likely to be repeated in 2023. The recent warm weather in Europe has provided energy cost relief for European corporates, but in our view will remain a significant risk and headwind through next winter.
Considering the economic backdrop, we expect negative rating migration in the coming quarters. Net rating migration and the composite PMI are strongly correlated historically. While many point to high interest coverage ratios as a strength, we expect the metric to deteriorate. Fifty percent of euro IG debt outstanding will mature by 2026.[i] Assuming maturing debt is refinanced at the current index yield (~4.5%), European IG corporates would see a €10-1€5 billion interest cost increase per annum.[ii]