Market Review & Outlook | Insight Investment | Insight Investment

The sharp upward move in both yields and spreads resolves some of the concerns we had with investment grade credit from a total return perspective. The position within the economic cycle is less supportive than before, with a more moderate pace of growth ahead, and central banks are responding to higher inflation by raising policy rates. Cost pressures are also a concern, with more evidence needed regarding how effectively firms have been in passing rising costs on to consumers. However, yields now arguably reflect the less positive outlook, at least to a degree.

Although investment grade credit is now trading at more interesting levels, we remain concerned about the potential for higher yields and therefore a neutral position to credit market exposures is warranted, although idiosyncratic opportunities that have arisen remain attractive.

The highly supportive environment that we have seen over recent years is starting to moderate, with a slower growth outlook, elevated levels of inflation and tighter monetary policy ahead. With market volatility rising after the conflict broke, new issuance has notably declined, running substantially below the levels seen at the start of 2021. Many issuers used the period of low yields and buoyant market conditions to extend maturity profiles and build liquidity buffers, increasing their flexibility on when to return to markets. We believe that a defensive position is most appropriate for now, with the risk off tone of markets likely to persist until the conflict is concluded and the peak in inflation is in place.

The Russian invasion of Ukraine sent an inflationary pulse around the world, with the two countries significant exporters of energy and key agricultural commodities. As a result, we believe inflation will now likely peak at higher levels than previously expected in many emerging markets, and that this will cause central banks to accelerate tightening programs, despite a potentially slower growth outlook.

We expect this to be a challenging environment for local rates, and the asset class more generally but we are most constructive on emerging market credit (largely denominated in US dollars), with the higher yields available in both investment grade and high yield issuers offering some value for dedicated emerging market investors.

The Russian invasion of Ukraine acted as a catalyst for a broad-based widening of spreads within structured credit markets, although spreads widened less than in other segments of credit markets. This appears to have been primarily driven by a decline in trading volumes, amplifying the impact of the move despite very limited actual selling pressure. Issuance moderated quickly as spreads widened, with some issuers having the flexibility to wait for better market conditions and others unable to issue during periods where capital structures are too expensive.

We would view the widening in spreads as an opportunity to increase exposure to high quality collateral pools which we expect to perform well even in an environment of higher inflation and interest rates. We favor issues with seniority in the capital structure, robust transaction structures that divert cashflow in the event of underperformance, and strong underwriting and servicing policies, all of which should act to insulate investors during economic downturns.

At a broad market level, elevated levels of inflation and a more hawkish Fed are creating a more challenging environment than we’ve seen for some time. The buy-and-hold nature of muni investors makes the market more defensive than other segments of credit markets, and dampens volatility, but is unable to fully protect against upward moves in yields. When looking at individual issuers, the story generally remains a positive one.

A continued economic recovery, generous federal aid and better than expected tax receipts are helping to bolster state and local government balance sheets, while strong equity returns have improved the funded position of pension plans.