As a volatile 2022 came to a close, we gathered with our fixed income colleagues to begin the great debate on the fixed income landscape of 2023. Below is a distillation of our best credit market ideas, including opportunities that we think will evolve over the course of the year, against a macro backdrop of slowing US and global growth.
Part 2 of this series, slated to publish later this month, will discuss what we see as the three best approaches to diversifying fixed income risk in 2023.
- Given the threat of recession this year, we believe long/short credit strategies should be able to navigate expected increases in market volatility and dislocations. As credit markets continue to grapple with persistent inflation and rising interest rates, there will probably be sharper investor focus on company earnings, free cash flows, debt sustainability, and other fundamental factors. Corporate profitability, while still in the green, may be challenged by a slower and more fragile global economy. As a result, we expect to find greater intra-sector and idiosyncratic dispersions and mispricings, with clear winners and losers emerging within different industries. In particular, there may be opportunities in some individual shorts that have yet to price in today’s looming economic realities.
- Investment-grade (IG) credit has begun 2023 at much higher yield levels than it began 2022. While IG credit spreads have widened, what seems more interesting are the portfolio implementation possibilities available for this high-quality asset class: 1) "low-touch” fixed-maturity strategies that prioritize income in pursuit of total return; and 2) dynamic Treasury/IG strategies. The former, where the life of the strategy approximates the maturity of the underlying bonds, locks in mid-to-high single-digit yields that (barring defaults) will likely be the strategy’s total return. Additionally, higher Treasury yields now offer some protection against spread widening in a slowing economic environment. The latter are focused credit strategies with IG average credit ratings and will significantly increase/decrease credit exposure as sector, issuer, and security valuations change. They are intended to serve as a positive convexity complement to core/core bond-plus portfolios or income-oriented strategies that hold static allocations to US credit sectors.
- Securitized credit presently offers high income generation relative to spread duration, potentially supplying a powerful cushion for the sector under a spread-widening scenario in 2023. While we expect stress on collateral performance to increase this year, we do not expect losses to rise materially. We think the senior parts of the securitized credit structure are likely to weather weaker collateral markets. Additionally, if the Federal Reserve’s “higher for longer” interest-rates stance holds relative to forward pricing, then the shorter-duration/ floating-rate dynamics of securitized credit may be set to deliver robust income through much of the year ahead. Overall, we believe securitized credit should fare better in a downturn relative to similarly rated corporate credit.
- If spreads widen in 2023, particularly in conjunction with elevated volatility and illiquidity, then CLO equity would be an interesting sector for allocators to consider in 2023. Making a levered credit investment on the cusp of a recessionary period sounds counterintuitive, but bank loan spreads have historically tended to overreact (relative to their historical loss-given-defaults) in their widening ahead of recessions and default cycles. The CLO vehicle can actively invest in those dislocations via a locked-up structure, with potential to enhance total returns through periods of market volatility. Critically, the CLO equity structure offers term, nonrecourse leverage without market value triggers — a rare and valuable feature, particularly amid volatility. Buying into elevated spreads using term financing in locked-up structures could be a powerful driver of total return.
- For the more deep-value credit investor, contingent convertible securities (CoCos) issued by European banks may present exploitable price inefficiencies due to regulatory, political, and regional differences among issuers. From a fundamental perspective, earnings for European banks have been on a positive trajectory and, in our view, should remain resilient despite ongoing economic and geopolitical headwinds. There are still very few signs of asset-quality stress, while recent underwriting has been supported by either direct government guarantees or indirect fiscal aid. Broadly, bank fundamentals look well positioned to cope with a deteriorating macro environment. However, we recognize that the exceptional technical support of recent years has started to fade, stoking volatility within the CoCo market. Market dislocations and higher funding costs will likely have disproportionate impacts on lower-quality names.
After significant credit spread widening, CoCos now appear attractive on historical, relative, and absolute bases and may become more so as 2023 unfolds, potentially creating favorable entry points. CoCos can either be standalone investments, or allocators can gain exposure via global high-yield and diversified credit strategies.