Credit outlook: The Fed's triumph

The die is cast. The Fed has lowered interest rates by a significant 50 basis points, officially declaring victory in the battle against inflation. With this rate cut, the Fed is signaling its intention to stay ahead of the curve, aiming to prevent the economy from suffering excessive damage due to tight monetary policy. During the last quarter, the labor market weakened further, and leading indicators point to a slowdown in the US economy.

The prevailing market consensus is that the Fed will succeed in achieving a soft landing, balancing the labor market without triggering a sharp rise in unemployment. While we agree with this consensus, we do not see this as the moment to increase portfolio betas. The margin for error is small, and as we saw in early August, the market can pivot quickly if the consensus shifts, even slightly, in the opposite direction.

The US economy appeared resilient to the series of rate hikes for a long time. The reasons are well known: expansive fiscal policy, ample fixed-rate corporate funding, and pent-up demand after Covid all played a role. Toward the end of the hiking cycle the market became increasingly convinced that a recession would be avoided. However, there was a brief moment of uncertainty when the Sahm rule was triggered following the July unemployment figures. The weakness in risk assets was short-lived, though, as the market seemed to have no doubt that the Fed would succeed in its mission.

We will continue to closely monitor the labor market to ensure it doesn’t weaken to a point where reflexivity could trigger a self-reinforcing downward spiral. While this is not our base case, it remains a risk scenario for which the market is currently offering little compensation.

Looking at companies in the credit universe, we see positive trends within the investment grade segment. Leverage (debt/EBITDA) is decreasing as profitability improves, though interest coverage is deteriorating due to rising interest costs, as low-coupon debt is being refinanced at higher rates. However, this poses no significant issue for most investment grade companies. In the high yield segment, there is more bifurcation. Higher-rated companies show both the ability and willingness to reduce debt, but the weakest high yield firms are struggling. These companies will likely need to reduce their debt through restructurings, where creditors may face partial write-downs.

As credit investors, our primary metric for assessing value in the market is to look at spreads. When examining 20 years of historical spread data, we observe that spreads across all segments of the credit market are relatively low. US investment grade credit, in particular, stands out with exceptionally tight spreads. In contrast, Euro investment grade credit appears more attractive relative to the US, as spreads hover just below the 20-year median. Within US investment grade, the long end of the curve is particularly expensive. Additionally, the spread compression between A-rated and BBB-rated bonds is near all-time lows in both Europe and the US. Given this backdrop, we favor up-in-quality trades but recognize that rigorous issuer screening is essential. Financials have outperformed non-financials, and we believe there is still room for further outperformance in this segment.

It is evident that the technical factor has been the primary driver of credit performance this year. Strong demand for credit led to substantial inflows into investment grade strategies. One major reason for these positive flows was the attractive all-in yield, which spurred high demand for annuity products in the US. We also observed significant inflows from target date funds. Although demand for high yield products was comparatively lower, this market still benefited from a strong technical.

The high yield market has remained relatively calm. However, with the onset of interest rate cuts, the leveraged loan market may become less attractive to yield-seeking investors. This could result in flows from leveraged loans into high yield bonds. On the supply side, we expect the high yield market to become more active. Lower all-in yields make leveraged buyouts (LBOs) more appealing to private equity sponsors, who are likely to tap into the high yield market to finance these deals.

In summary, the technicals remain robust, but prudence is advised. Historical patterns demonstrate that this factor can reverse abruptly, as seen during the initial period of August.