The return of inflation has marked a truly turbulent year for fixed income investors. Ongoing supply chain disruption, spiralling energy costs and tight labour markets have resulted in significant pricing pressures across much of the global economy.
Stubbornly high-cost inflation has forced central banks to aggressively tighten monetary policy. From January 2021, eleven developed market central banks have hiked rates 57 times between them resulting in a combined 2,700 basis points of interest rates increases, according to Bloomberg, as of 21 October.
The unprecedented pace of tightening has had significant knock-on effects on global credit markets, which have been forced to sharply reprice as underlying government bond yields have risen. The Bloomberg Global Corporate index has fallen 17% in 2022, according to Bloomberg as of 18 October, hedged to USD, on track for its worst year on record.
Fundamentals rolling over but valuations
Investment grade (IG) credit markets entered this downturn in a relatively robust position following a period of deleveraging since peaking just after the pandemic. As of June 30, 2022, US IG, gross leverage has fallen to 2.5x EBITDA (earnings before interest, taxes, depreciation and amortisation), below the pre-Covid level of 2.8x.
European companies have seen similar levels of deleveraging, falling to 2.5x EBITDA, its lowest levels since late 2017 (J.P Morgan Asset Management). Despite meaningful improvement in leverage ratios, deteriorating economic conditions and ongoing margin pressure has stalled further de-leveraging. This tougher economic backdrop and worsening credit fundamentals are reflected in current IG valuations. As of 17 October 2022, the option-adjusted spread (OAS) of US IG corporates had reached 164 basis points, implying a 50% probability of recession within the US (Bloomberg). Valuations in Europe are at even more elevated levels as investors look to factor in the ongoing energy crisis. European IG OAS are at 232 basis points, according to Bloomberg, as of 17 October, implying a 90% probability of a recession in the region.
However, overall yields are beginning to look historically attractive. The yield-to-worst on US IG corporates rose to 6.13% as of 19 October, its highest level since June 2006 (Bloomberg). While valuations are beginning to look historically attractive, investors need to have a plan for navigating potential downgrades in the coming quarters.
During recessions, the biggest concern for credit investors is avoiding potential “fallen angels”, issuers that are downgraded from investment grade to high yield following a deterioration in their credit fundamentals. Having exposure to issuers that are transitioning from investment grade to high yield can often be highly disruptive for investors unfortunate enough to be holding onto the debt of downgraded companies, either via direct, active exposure or passive benchmark holdings. For example Ford, which underwent a downgrade to high yield in March 2020, saw spreads on its 10-year bond widen by 803 basis points between 3 March and 23 March 2020 (Bloomberg).
Ongoing central bank tightening and slowing growth may create more fallen angels.
As the chart demonstrates since 2000 IG credit has undergone nine credit bear markets. Historically during credit bear markets, approximately 4% of the US investment grade universe has been downgraded to high yield. However, not all downgrade cycles are made equally. During more recent downturns in 2016 and 2020, the level of downgrades has been relatively muted as loose monetary policy and generous fiscal programmes have helped mitigate the impact on credit markets. In the coming downturn, the total number of downgrades may look closer to the long-run average of 4% as stubbornly high inflation prevents policymakers from significantly easing financial conditions, potentially leading to more downgrades.
Source: JPMAM, Barclays. Credit bear markets defined as periods where fallen angels outweigh rising stars by at least $5bn over a calendar year (2000, 2001, 2002, 2005, 2008, 2009, 2010, 2016, 2020).
The average is based on those years. Severe recession is mid to high single-digit EBITDA T12m YoY % deterioration at an index level. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
Some active management can go a long way
While challenging market conditions and the possibility of a heightened level of downgrades do present a problem for investors, a small amount of active management can go a long way in helping protect a portfolio from the disruption caused by falling angels. Our JPM Corporate Bond Research Enhanced Index (ESG) ETFs*,** (CREIs) focus on efficiently replicating the risk profile of the credit investment universe whilst adding value predominantly through security selection. By systematically incorporating our proprietary security rankings produced by our credit research analysts, we aim to tilt the portfolios towards issuers we believe will outperform away from those we think will underperform, particularly issuers at risk of being downgraded. This approach can help investors navigate these challenging markets by avoiding the losers rather than just picking the winners.
The CREI range includes three exposures investing in EUR, EUR 1-5yr and USD Corporate Bonds**. Our credit scoring approach incorporates financially material ESG considerations, social and governance (ESG) considerations into its assessment of individual issuers. The JPM Corporate Bond Research Enhanced Index (ESG) ETFs*,** are classified as Article 8 under the SFDR regulation, due to the exclusion of controversial industries and integrating financially material ESG factors throughout the investment process.
Find out more about EUR Corporate Bond Research Enhanced Index (ESG) UCITS ETF:
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***Integrating financially material ESG factors into their usual forms of analysis to identify risks and opportunities in different investment, but without changing the investment objective or constraining the universe of potential investments. ESG determinations may not be conclusive and securities of companies/ issuers may be purchased and retained without limit by the investment manager regardless of potential ESG impact.
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