In the hit movie Honey, I Shrunk the Kids, the children were left bewildered when everything in their world became outsized. Credit investors, too, might find themselves perplexed when trying to marry the rosy sentiment and extreme valuations with the many risks and uncertainties muddying the outlook for corporate bonds. But this is not science fiction, this is simply technicals and the technical picture is dominating the fundamental like never before, with the former requiring less logical justification than the latter. It’s not long after a bond shoots higher in the market without an obvious reason that someone on our desk quips, “more buyers than sellers”. This sentiment is true of credit more broadly today. Moreover, both sides of it – the demand and the supply – are equally responsible.
The demand side is perhaps more obvious at first glance – yields in credit are standing on their own two feet in a way rarely seen since the financial crisis. Boosted by underlying government bond yields, credit is now delivering more superior income than dividend stocks. At a time of uncertainty over companies’ ability to protect margins and maintain growth rates, the certainty of coupons over the discretionary nature of dividends is attracting asset allocation flows from equities to credit. Knowing that these elevated yields may not last much longer due to impending central bank monetary policy easing, there is also a growing band of money moving from “the sidelines” of cash and near cash into credit in an attempt to lock in favourable levels. In short, all routes are leading to credit in a sweet spot for asset allocators.
Less well appreciated is the supply side – there is a distinct lack of paper to buy. This is most pronounced in the high-yield market which has seen its size shrink by 10 per cent in a little over a year. Companies are issuing less as they de-gross their debt burdens to adjust to the new normal of higher interest rates, and therefore lower levels of debt appropriate to maintain sensible interest coverage ratios.
M&A, having fallen off a cliff, has also restricted the amount of issuance slated for the purpose of sponsor funding. Lastly, many treasurers have been choosing to hold off refinancing activity until nearer existing debt comes due. Why replace a 5 per cent coupon with an 8 per cent coupon until you have to? Rating agencies have been busy upgrading, fuelling impressive levels of “rising stars” relative to “fallen angels”. And all of this is before we contend with a new competitor for debt capitals funding – the private credit market – which has now grown to some 30 per cent of all leveraged finance having been less than 10 per cent just a decade ago.
The counter to joining in the grabathon is based around declining fundamentals and tight spreads. At current levels, very little in the way of a default cycle is priced in. While balance sheet health and earnings momentum have been impressively robust in the face of rising interest rates, it is hard to argue for continued improvement on either.
However, there is an element to all this that is self-fulfilling. With the primary market starved of action and increasingly wide open for refinancing, amend and extend deals and the like, the “wall” of maturities corporates face in 2025 and 2026 is increasingly being eroded away, meaning that positive technicals are creating positive fundamentals and driving down default rate expectations.
That is a difficult backdrop to fight against. But just like the children navigating their jungle-like backyard in the movie, investors will inevitably encounter various obstacles and dangers. These may not be voracious insects, giant raindrops, and gargantuan lawnmowers, but rather idiosyncratic cracks appearing in the lowest rungs of the market, ready to dispense permanent loss of capital.
CCC-rated debt does not enjoy the resilience of the rest of the spectrum – “It’s a jungle out there!” as Wayne Szalinski put it. Already there and in the leveraged loan market, capital structures are straining with the reality of non-zero interest rates. Indeed, in these segments, we are seeing twice the ratings downgrades to every upgrade, significant structural issues in troubled sectors such as telecom and media, and some governance issues popping up as cash flows come under scrutiny.
The path from here for most credits is constructive and is arguably getting more constructive via feeding off the strong technical. But expect idiosyncratic events, dispersion in the lowest tier, and some losers to emerge. While recalling classic 80s movies, remember that good, old-fashioned company selection based on rigorous fundamental analysis will once again come to the fore.
Fraser Lundie, head of fixed income, public markets, Federated Hermes Limited
