Rising inflation and interest rates have created significant opportunities in credit, but with crosscurrents investors must actively navigate
Economic fundamentals have shifted sharply this year. After decades of low inflation, rates have risen materially due to a pandemic-induced change in demand toward goods, supply chain bottlenecks, aggregate stimulus and post-pandemic recovery, a shock to labour supply and now supply shocks to energy and food as a result of the Russia-Ukraine conflict.
Median global inflation is expected to be 7.5-7.9% in 2022 vs. approximately 4.5% a year ago.1 in Europe, inflation ranges from 6.6% in France to 25.2% in Estonia, resulting in an average of 10% for the eurozone – a record high.2 To combat inflation, central banks are tightening monetary policy, decelerating the economy and heightening recessionary fears.
This unusual scenario has left no place to hide, resulting in a sell-off across both equities and traditional fixed income. The typical relative protection and diversification benefits of fixed income have been disrupted, as higher interest rates have put significant pressure on bond prices. Meanwhile, inflation and recession concerns weigh on corporate earnings, which result in more volatile credit spreads and equity prices.
This volatility may push investors back to the relative safety of fixed income as rates increase, but they may need to look beyond traditional credit securities to find the performance they need. While the task of finding returns may seem daunting, pervasive uncertainty creates a compelling environment for opportunistic investors.
From niche to mainstream
Credit markets currently have over $17 trillion of assets under management, with private credit over $1.2 trillion of that total – reflecting the asset class’s evolution over the past decade from a niche to one of the fastest growing segments of private markets, as companies seek alternative sources of financing outside of traditional publicly traded markets.3
With volatility in public markets and banks’ lending activities under pressure, many companies are turning to private credit for the financing they need. This is particularly true of companies that faced disruption during the pandemic, or that are seeking funding for a transformative acquisition, and which may therefore struggle to obtain that financing from banks or in the public debt markets. The pipeline of private capital solutions opportunities remains robust, with strong demand from companies seeking to finance growth projects and potentially overdue capital expenditures.
However, when lending to companies to finance growth, investors are best served by requiring coverage from existing businesses, such as first liens on property, plant and equipment (PP&E), and not solely relying on pro forma cash flow projections.
Unearthing select opportunities
While public markets have not performed well overall, as always, there are still interesting opportunities for investors willing and able to take the time to sift and scrutinise the options. There is a disconnect between the recent market sell-off and business fundamentals, which are still broadly healthy. High-yield spreads have increased significantly, but there has not been an uptick in restructurings or stressed issuers seeking liquidity, and default rates are still near the all-time lows we have experienced in Europe for an extended period.4 While we are expecting a short-term increase from current levels, we do not predict a full default cycle as seen in previous recessionary environments such as the tech bubble, the Global Financial Crisis, the euro sovereign crisis or the commodity crisis. For 2023, the market consensus is for default rates of 3-4% at the broad market level, meaning there are opportunities to find companies that have been unfairly dragged down by bearish sentiment5.
As inflation and economic slowdown take their toll, some companies may start to publish challenged operating results while others emerge relatively unscathed. Investors should avoid businesses where supply chain bottlenecks can materially disrupt revenues, input costs are not easily passed on to consumers, and cash burn necessitates capital markets access, particularly in growth-oriented companies where investors have lost conviction. (However, many issuers do not have near-term financing needs, having used the 2020 rebound to extend the terms of their debt at favourable rates). Instead, investors should focus on performing credits trading at attractive levels, targeting opportunities with capital structure seniority, asset coverage and/or upcoming events to catalyse a change in price.
Navigating the year ahead
While a deep recession with an extreme default spike is not expected, there are trends investors should bear in mind with both public and private credit markets.
Persistent inflation is creating a range of challenges for companies, including rising labour, energy and input costs. At the same time, many are increasing production costs as they try to improve supply chain resiliency and bring production closer to their customers. Skyrocketing energy costs – alongside a focus on energy transition – are issues almost everywhere. However, higher costs are likely to impact the fundamentals of countries, markets, sectors and individual companies in different ways which investors must assess.
In order to adapt more efficiently to the changing market conditions, investors are leaning on companies in developed markets, particularly in the US, as well as companies with pricing power and variable cost structures, such as technology and services businesses.
The cost of debt is rising, as years of ultra-accommodative monetary policies and lower interest rates come to an end. Companies must now adapt to a higher cost of capital – which may have a substantial impact on their business models and their financing needs. It will have a particular effect on companies that have relied on rolling over debt cheaply – these “zombies” will have difficulty surviving in a stagflationary environment.
Risk premiums and public market volatility are also growing, leading more companies to turn to private markets for financing solutions. However, some companies have accepted that the environment of higher rates and therefore higher costs in public markets is here to stay for an extended period, and are choosing to refinance and extend maturities now, rather than gambling on potentially even higher costs in 2024 with an even larger mountain of near-term debt to refinance. Overall, the cost of capital is higher for both public and private issuers - a thematic change that is likely to have a broader impact going forward.
After years of low interest rates and low inflation, investors may find this new world of both higher rates and inflation unsettling. Adapting to these new economic and market conditions, while keeping a strong focus on individual market, sector and company fundamentals, will be key to finding the best opportunities in fixed income.
Produced by EI Studios, the custom division of Economist Impact.
1https://www.euromonitor.com/article/global-inflation-tracker-q2-2022-energy-dependent-countries-under-pressure, June 17, 2022
2https://ec.europa.eu/eurostat/web/products-euro-indicators/-/2-30092022-AP#:~:text=Euro%20gebiet%20jährliche%20Inflation%20ist,Büro%20der%20Europäischen%20Union, September 29, 2022; https://www.statista.com/statistics/225698/monthly-inflation-rate-in-eu-countries/#:~:text=Ab%20von%20August%202022%2C%20der,der%20EU%20während%20dieses%20Monats, November 17, 2022
3Bloomberg. Total USD market value of debt outstanding across global corporate bond indices as of May 31, 2022; Preqin global private credit assets under management, as of September 30, 2021
4 https://www.trustnet.com/news/13344551/if-default-rates-stay-low-high-yield-bonds-more-than-compensates-investors-for-the-risk#:~:text=Europäische%20Verzugszinsen%20durchschnittlich%202,9,nachlaufende%20Verzugszinsen%20zu%202,1%25, November 22, 2022
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