Credit Outlook: Focusing on fundamentals

Introduction

The past year saw borrowers adapt to a very different world, as surging inflation, interest rate rises, and recession fears took hold. Credit conditions tightened, public debt issuance volume dropped sharply and pricing widened. Heading into 2023, it’s difficult to make the case for a significant change in the environment without material improvement in the economic outlook. We think that’s unlikely given the new inflationary and interest-rate regime, but we do see reasons for optimism, with strong fundamentals across public and private credit, and the markets offering an attractive entry point for investors over an intermediate time horizon.

There are three main themes we are watching as we move into the first quarter, each of which influences our asset-class and geographic preferences.

• Volatility in public debt markets: This influences the behavior of borrowers and lenders, creating new challenges and opportunities for investors.
• Inflation’s impact on credit fundamentals: Higher costs and tighter financial conditions may force companies to rethink their business models.
• Restructurings and defaults: When markets change, companies may need capital to pivot. Opportunities typically arise in challenging times like these.

Theme 1: Volatility

A sharp decline in global M&A volumes led public debt market issuance volumes to their lowest levels since the Global Financial Crisis. This came after a record year in 2021, by most estimates, when many companies took advantage of favorable conditions to refinance their existing debt. That extended the maturities of the majority of outstanding loans and bonds to 2024 and beyond.

Although issuance picked up slightly in the fourth quarter, public debt markets were effectively closed for most of 2022 as pricing widened, causing more large-cap companies to access the private credit markets for financing.

Theme 2: Inflation

Rising rates impact businesses directly by increasing debt service costs, and indirectly by reducing customer demand. Slower growth, with potential recessions in the world’s largest economies, is undermining business and investor confidence, and affecting supply and demand dynamics in credit markets globally. Increased geopolitical risk, from Russia’s invasion of Ukraine to growing U.S.-China tensions, adds complexity to an already uncertain landscape.

High and volatile costs, such as wages, which are rising at a historically high level of 5% in the U.S.¹, and commodities, are adding uncertainty along the value chain that businesses must continue to adapt to.

But at the same time, the credit quality of issuers – both public and private - is, on the whole, much better than it was at the beginning of the Covid pandemic, based on the current high levels of interest coverage ratios and lower leverage levels, as shown in the chart.

Theme 3: Restructurings and defaults

Slowing growth inevitably drives balance sheet restructurings, as well as the potential for increased default volumes.

For credit investors, it is important to consider how the market prices in potential negative outcomes, versus the actual results. This is where mitigants to credit losses such as deal structures and attachment points can be decisive. A lender’s ability to use these tools to navigate challenges can improve potential outcomes significantly.

The majority of defaults occur when issuers are unable to refinance maturing debt. But the majority of the public market debt that was due to mature this year was refinanced in 2021, based on that year’s record volume of high-yield refinancing. The lack of a maturity wall in the public debt markets this year should help keep default rates low.

Some companies aren’t built to withstand the stress of a potential recession. And in those situations the availability of capital to solve a problem may make the difference between default and weathering near-term uncertainty to reach longer-term growth. This is one more reason why credit selection in this environment is absolutely critical.

Regional view: U.S.

The U.S. growth picture appears relatively attractive, with inflation peaking at lower levels and beginning to ease faster than in Europe. Whether a technical recession occurs or not, we expect any downturn to be relatively mild. Key macro considerations in the U.S. in early 2023 include Federal Reserve policy and improving inflation data, which should allow the Fed to reduce the scale of tightening.

Based on the prices we’re seeing, the market’s current projections for Fed funds suggest that rate cuts may come as soon as May. But we remain skeptical and believe a persistently high rate is likely to be maintained until inflation declines more significantly. Greater variation around economic data projections is likely to keep volatility elevated.

Regional view: Europe

The effects of inflation, rising interest rates and the consequences of Russia’s invasion of Ukraine shaped the European credit market throughout 2022. And those factors should continue to play a role, at least through early 2023.

In this environment, the ability of borrowers to meet higher financing costs is a critical area of focus, particularly in private-credit markets that are predominantly floating rate.

On the whole, however, the credit quality of the European debt universe is good, with relatively few CCC-rated issuers (those most likely to default) in the public debt markets.

Regional view: Asia

Since mid-2021, volatility and illiquidity in public credit markets have led to a slew of credit events related to redemptions, notably in Chinese high-yield, and specifically related to real estate.

Investor confidence in public credit markets is low, leading to a decrease of more than 90% in year-over-year high-yield issuance, in our estimations. That has led to an increase in private-credit deal flow.

The Asian credit default rate is ~13% year to date, but only 1.2% ex-China property, according to data from JP Morgan. The prospect of easing lockdowns in China and the announced plans to provide support for the property sector are promising developments, though our view remains cautious. We are focused on higher-quality opportunities.