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

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

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Sep 23 (Reuters) – U.S. high-yield corporate debt markets could undervalue recession risk even as Treasuries and macro indicators reflect mounting growth fears, but that could be put to the test soon, with corporate earnings set to deteriorate.

The prices of leveraged loans and high-yield corporate bonds have fallen from the highs reached earlier this year as rates rise and their spreads over benchmark rates widen, but they still reflect relatively optimistic economic outlook.

“Credit spreads are too tight, they don’t sufficiently reflect the risk of recession. Other models we use, whether it’s the yield curve or hard macro data, are more bearish,” said Matthew Mish, head of credit strategy at UBS, adding that at one point given “they must converge”.

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

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

Their borrowing rates have been kept under control by strong liquidity, while default rates are close to all-time lows and are not expected to rise significantly in the near term.

Earnings were better than expected in the second quarter on average, but higher rates and slower growth are expected to squeeze earnings further soon, which could lead to rating downgrades and higher default risk.

“There is certainly more concern about this downside risk and potential recession fears, but this is not being adequately reflected in price as the fundamentals in place are still sound and the positioning is already defensive,” he said. said Srikanth Sankaran, head of US and European credit at Morgan. Stanley.

Many fund managers say they are wary of the outlook. The risks are likely to be seen first in lending, which has seen rapid growth, higher leverage, declining credit quality and looser credit conditions in recent years, even as the market for High yield bonds saw an overall improvement in credit.

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

The risks are not evenly distributed, with many pointing to the segment of high “B” rated leveraged buyout (LBO) loans, the second lowest level before default, as causing the most problems.

Scott Macklin, director of leveraged lending at AllianceBernstein, sees the risk of many of these B companies downgrading to the CCC zone, the lowest rating tranche, as they face higher borrowing costs. higher and lower profits. The fund manager thinks this could eliminate almost all of the average unhedged issuer B’s free cash flow.

“There is currently moderate concern in loan prices, although we don’t think the market has fully grasped the fact that many businesses simply cannot afford the higher interest charges, d especially as demand moderates,” he said. .

POCKETS OF OPPORTUNITY

Although the outlook is risky, a greater bifurcation between credit performance also creates opportunities.

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

While the probabilities of a “soft landing and moderate recession” are already factored in, a hard landing is not yet expected, he noted.

Vanguard’s Chang still sees opportunities in sectors that are benefiting from a recovery in demand as the economy reopens from COVID shutdowns, such as airlines, accommodation and gaming. However, the company maintains a defensive posture and a quality bias.

AllianceBernstein’s Macklin notes that at current spreads of around 500 basis points on the JP Morgan Leveraged Loan Index, loans could see an 8% default rate for each of the next 5-6 months. years.

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

The coming quarters could determine whether the market remains ripe for credit selection or if there is more widespread deterioration in prices and credit quality.

“For now, the credit market is still reassured by the fundamentals in place and its slow deterioration. I think the next two earnings seasons will be a critical test for that assumption,” Morgan Stanley’s Sankaran said.

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Editing by Alden Bentley and Chizu Nomiyama

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