Analysis: Credit markets see less risk of recession, earnings may challenge that

The New York Stock Exchange (NYSE) is seen in the financial district of New York, United States, January 13, 2021. REUTERS/Shannon Stapleton

23 September (Reuters) – US high-yield corporate bond markets may understate the risk of a recession even as government bonds and macroeconomic indicators reflect rising growth fears, but that could soon be tested as corporate earnings are expected to deteriorate.

Prices of leveraged loans and high-yield corporate bonds have fallen from record highs reached earlier this year as interest rates rise and their spreads versus benchmark rates widen, but they still reflect a relatively rosy economic outlook.

“Credit spreads are too narrow, they do not adequately reflect the risk of a recession. Other models we use, whether it’s the yield curve or macro hard data, are more bearish,” said Matthew Mish, head of credit strategy at UBS, adding that “these have to converge at some point.”

UBS said spreads on high-yield or “junk” bonds and leveraged loans imply 25-30% chances of a recession, while other models show a 55% chance of a downturn.

Leveraged loans and junk bonds are high-risk corporate bonds. Loans typically have variable interest payments and a secured claim on a company’s assets in the event of default, while bonds are unsecured and often have fixed interest rates.

Their borrowing rates have been kept in check by solid liquidity, while default rates are near historic lows and are unlikely to rise significantly anytime soon.

Earnings were better than expected on average in the second quarter, but higher interest rates and slowing growth are likely to weigh more heavily on earnings soon, which could mean rating downgrades and higher default risk.

“There are definitely more concerns about this downgrade risk and potential recession concerns, but it is not adequately reflected in the price as fundamentals are still healthy and positioning is already defensive,” said Srikanth Sankaran, head of US and European credit at MorganStanley.

Many fund managers are cautious about the prospects. Risk is likely to be seen first in credit, which has experienced rapid growth, higher leverage, declining credit quality and looser credit conditions over the past few years, even as the high yield bond market has seen credit quality improvement overall.

“The credit quality of the credit market is lower today than it has been in the past,” said Michael Chang, Vanguard’s head of high yield credit, adding that “although valuations have improved, risks are still elevated.”

Risks are not evenly distributed, with many pointing out that the leveraged buyout (LBO) segment, with its heavy “B” rating, the second-lowest level before default, is the top concern.

Scott Macklin, AllianceBernstein’s director of leveraged loans, sees the risk of a multitude of downgrades from these B companies to the CCC, the lowest rating band, as they face higher borrowing costs and lower yields. The fund manager believes this could eliminate essentially all of the free cash flow of the average unhedged B issuer.

“Credit prices are reflecting some concern at the moment, although we don’t think the market has fully addressed the fact that many companies simply cannot afford to pay the higher interest costs, especially if demand slacks,” he said he .

POSSIBILITIES

While the outlook is risky, a widening split between corporate bond performance also creates opportunities.

Anders Persson, chief investment officer for global fixed income at Nuveen, said the company is “getting into” high yield and leveraged loans, with a focus on better quality “BB” and high “B” rated companies, even if it is “Expect more volatility.”

While the likelihood of a “soft landing and mild recession” is already priced in, a hard landing is not yet the case, he noted.

Vanguard’s Chang still sees opportunities in sectors that will benefit from a rebound in demand as the economy reopens from COVID shutdowns, such as airlines, accommodation and gaming. However, the company maintains a defensive stance and a quality upgrade.

AllianceBernstein’s Macklin notes that with current spreads in the mid-range of 500 basis points, loans could experience an 8% default rate for each of the next 5-6 years, according to the JP Morgan Leveraged Loan Index.

That’s “far higher than any stretch in history and still likely a higher return than money market funds, offering a solid risk-reward profile for long-term investors,” he said.

The next few quarters could decide whether the market remains ripe for credit selection or whether prices and credit quality across the board continue to deteriorate.

“For now, the credit market is still being comforted by existing fundamentals and slow deterioration. I think the next few earnings seasons will be a critical test of that hypothesis,” said Morgan Stanley’s Sankaran.

Edited by Alden Bentley and Chizu Nomiyama

Our standards: The Thomson Reuters Trust Principles.