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    Credit - the asset class to watch for the mid cycle

    Credit - the asset class to watch for the mid cycle

    December 09, 2021 Fixed income

    As the US recovery graduates from the 'early' to the 'mid' cycle, we expect growth to moderate from 'very high' to 'high'. As such, lower-rated credit may be the risk asset class to watch.

    Summary


    Equity market tailwinds are starting to moderate

    The fastest economic recovery in history, driven by unprecedented technical market support from the Federal Reserve (Fed) and the Treasury, has been kind to the highest risk ‘growth’ assets.

    As such, since the pandemic-downturn of March and April 2020, equity markets have had an excellent run.

    However, as we transition from the ‘early cycle’ phase of the recovery to the ‘mid cycle’, we believe growth will likely remain solid, but lower at the apex of the recovery. This may make for an increasingly positive relative value environment for higher yielding credit.

    The traditional 'mid cycle slowdown' explained

    History shows that equity markets tend to perform strongly following a downturn as the economy ‘bounces back’. However, as the economy’s ‘low hanging fruit’ gets plucked (e.g. the easy job gains from the post-COVID reopening), the pace of growth becomes harder to maintain.

    The transition to mid cycle tends to be when monetary stimulus is scaled back or withdrawn, as reflected by the Fed ‘tapering’ its asset purchases.

    In the past, equity markets have sometimes experienced pricing corrections and higher volatility as markets recalibrate to a new growth trajectory.

    Higher-yielding credit may therefore be the asset class to watch

    High yield and lower-rated credit tend to look attractive mid cycle

    When economic growth moderates from high levels, higher yielding fixed income credit markets tend to perform best on an excess return basis (Figure 1).

    Figure 1: Moderating growth is the sweetspot for lower-rated credit1

    Moderating growth works well for credit investors because it implies continued revenue and earnings growth, allowing for companies to de-lever organically, which typically leads to improving credit metrics. The highest growth environments have actually historically been less compelling for high yield on an excess return basis, as they have tended to be early cycle periods in which rates tend to fall, propelling government bonds and equities more than high yield credit.

    Moderating growth tends to be less positive for equities, given the downward adjustment in growth expectations from ‘very high’ to merely ‘high’ levels.

    Three reasons we believe lower-rated credit may outperform high-grade credit in a moderating growth environment

    In our view, BBB and BB credits offer more compelling value than high grade credit (single A or above) in a moderating growth environment.

    1) Interest rate risk is less of an issue for BBBs and BBs

    High grade credit returns are often dominated by interest rate risks, and during the mid cycle is when monetary accommodation is typically scaled back or reversed.

    The Fed is now ‘tapering’ its asset purchases (see Instant Insights: Taper time) and potentially set to commence a ‘lift off’ in interest rates shortly after tapering is complete. It is also important to recognize that corporations have taken advantage of low rates to issue longer-dated debt, increasing the interest rate sensitivity of the investment grade corporate index relative to its history. High yield bonds, however, tend to be shorter-dated, with credit spreads rather than duration having greater influence on total returns (see: High yield corporates have behaved well during rising rates)

    2) Lower rated companies are incentivized to de-leverage

    As growth moderates, and organic growth becomes less easy to deliver to shareholders, equity investors often pressure corporates to inorganically improve equity returns through share buybacks or M&A.

    However, these activities increase corporate leverage. Therefore, the companies most prone to this behavior tend to be single-A rated companies or above, as they have the greatest room to increase leverage. Even if it inflicts a credit ratings downgrade, the spread penalty for downgrades from single A to BBB has been relatively low (Figure 2).

    Figure 2: A rated companies face little spread penalty for a downgrade to BBB2

    BBB and BB companies, by contrast, have little incentive to pursue activity that will result in credit ratings downgrades, as the penalty becomes more severe the further down the ratings spectrum companies venture.

    In fact, many BBB and BB companies are former A-rated corporates that were downgraded due to previous M&A deals. They are now on a path toward de-leveraging. BBB companies are incentivized to avoid a downgrade into high yield territory and BB are incentivized to chase an upgrade to investment grade.

    We call this phenomenon, in which corporate ratings tend to gravitate to BBB, the ‘ratings cycle’ (Figure 3) (also see Credit Insights: Beware the Single A and Catch a Rising Star: Fallen angels may hold the key for more)

    Figure 3: The ratings cycle typically favors lower-rated credits during the mid cycle3

    3) The high yield ‘compression trade’ may have more room to run

    High yield credit spreads have generally lagged the recovery in investment grade markets since the start of the pandemic, leaving a sizable premium between the two.

    As such, we believe potential rising demand for high yield means there could be more room for high yield spreads to compress (Figure 4).

    Figure 4: There could be more for investors to squeeze from the high yield compression trade4

    Playing high-yield credit opportunities in a bond-picker's market

    Investing in lower rated credit always needs to be done with care, with the aim of avoiding the ‘losers’ on their way to distress or default. Sector and security selection is therefore important. In our view, there are three broad themes investors may wish to consider.

    1) Pivoting to sectors set to benefit from productivity growth

    We also believe that US growth is likely to become increasingly driven by corporate R&D and, as a result, productivity growth. In the US, business spending on equipment, structures and software reached 6.7% in the first half of 2021 – the strongest pace since 19845. Part of this has been driven by the need for remote working due to the pandemic.

    Almost all sectors have already been benefiting from productivity growth, with output largely rising despite fewer workers (Figure 5). However, the full fruits of this uptick in business investment will potentially improve productivity growth further.

    Figure 5: Productivity growth has been improving across many sectors6

    Beneficiaries may include industrials and other sectors leaning into the growing digital economy, as well as semi-conductor suppliers that are expanding production to meet rising demand for equipment. South Korea, for example, plans to spend roughly $450bn, led by its electronics giants, to build the world’s biggest chipmaking base over the next decade.

    2) Global credit outside the US may benefit from a catch up in GDP

    The US had a head-start on the economic recovery due to the relative size of its fiscal response and rapid initial vaccine rollout. Much of the rest of the world is now catching up. As the US moderates into the mid cycle, its peers are only just beginning their early cycle recoveries (Figure 6).

    Figure 6: The US had a head start on many countries in its recovery7

    As such, investors may wish to cast their net beyond US dollar credit, and consider opportunities across the globe, both in developed markets and emerging market debt (see Capturing inflation-related opportunities in emerging markets).

    Closer to home, the performance of global markets will also potentially benefit US exporters, as we expect the worldwide recovery to ease the US trade deficit (Figure 7).

    Figure 7: US exports may rebound as the rest of world sees a delayed recovery 8

    3) Fallen angels could be the key to capturing rising stars

    Targeting the fallen angels market may offer a compelling proposition for investors as fallen angels have historically delivered equity-like returns with bond-like volatility (Figure 8).

    Figure 8: Fallen angels have delivered equity-like returns for bond-like volatility9

    Historically, rising stars (high yield issuers that are upgraded to investment grade) have been almost twice as likely to come from the fallen angel market than the broader high yield market10(see Catch a Rising Star: Fallen angels may hold the key for more). We see the potential for a solid increase in rising stars next year given the strong economic backdrop

    Now is the time for a mid cycle playbook

    With the ‘easy part’ of the US recovery out of the way, we believe more investors should consider this a potential sweetspot for BBB, BB, ‘fallen angels’ and global credit (including both developed and emerging market debt).

    In our view, higher yielding credit sectors could be the risk asset class to watch for the mid cycle phase of the current economic expansion.

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