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2022 Outlook
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January 05, 2022

Corporate Performance to Support Credit Spreads

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January 05, 2022

Corporate Performance to Support Credit Spreads


2022 Outlook

Corporate Performance to Support Credit Spreads

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January 05, 2022

 

Executive Summary

  • We remain constructive on credit, with current market conditions consistent with the early expansionary phase of the business cycle
  • We expect corporate earnings to remain strong, balance sheets conservatively managed, and economic policy accommodative, all combining to support low default rates in the year ahead
  • Although the markets will likely see bouts of volatility, our base case is for credit spreads to trade in a range for 2022
  • Credit looks fully valued so we are biased to taking exposures through default risk, particularly in pockets like High Yield and Emerging Markets, rather than through generic market risk. In this environment, we believe the focus on bottom-up selection will remain a crucial source of returns.
 
 

Does the recent spread widening signal a regime change?

Four pillars supported credit markets for much of 2021, leading to assets looking fully valued…

  1. Easy financial conditions driven by stimulative monetary and fiscal policy
  2. Economic growth rebound supported by vaccinations and economies reopening
  3. Corporates performing well with management focused on a conservative strategy
  4. Excess liquidity supporting company refinancing and low default rates
     

…But markets are ending the year concerned that the backdrop has changed, causing credit spreads to widen.

  1. High inflation is increasing the risk that financial conditions tighten
  2. The pandemic is mutating, causing increased risk of new global lockdowns
  3. Fiscal measures are not affordable either politically or financially given the level of public debt
  4. Central bank corporate buying programs are expected to be curtailed
  5. Credit looks fully valued
     

The credit spread widening in November 2021 could be interpreted as “indigestion,” or a signpost to a new regime where the macro economy is less supportive.

Considering the business cycle, current market conditions are consistent with the early expansionary phase (Display 1). Corporate strategy is conservative (management still has concerns over the pandemic), economic policy is accommodative, and liquidity is plentiful, creating a goldilocks backdrop for credit investors.

 
 
 
DISPLAY 1: Current market conditions are consistent with early expansion
 

Provided for illustrated purposes only

 
 

We do not see signals that we are entering a late cycle, but we do expect volatility in 2022. We expect the market will overpredict the next downturn, likely focusing on either a policy error by central banks, or an escalation in the economic slowdown caused by new developments in the pandemic.

We expect spreads to be rangebound in 2022, between the approximate long-run average where we are currently, and the tights of 2021.

Corporate performance is expected to remain strong in 2022, supporting credit spreads

STRONG EARNINGS EXPECTED TO CONTINUE: Under the umbrella of the pandemic, corporates have managed costs efficiently to support profitability. Looking to 2022, while there are concerns that profitability will be impacted by higher costs, forward guidance suggests many industries have pricing power, i.e. the ability to raise prices, to help protect profitability.

BALANCE SHEETS WILL STAY CONSERVATIVE: While we remain under the influence of the pandemic, company managements are expected to remain cautious. Cash balances built up to weather uncertainty will be retained, and significant investment or strategic change will be delayed until the outlook becomes clearer. While we have seen some increase in debt at high quality corporates (A-rated or higher), these companies have the capacity and flexibility to manage the increase, with debt costs low and central banks providing liquidity in recent times for the Investment Grade (IG) sector.

M&A RISK WILL CONTINUE: Deal volume is expected to increase in 2022. Much of the activity will see divisions divested to sponsor companies or industry consolidation funded conservatively with a combination of debt and equity.

MODERATELY INCREASING CAPEX: Capital expenditure (capex) has been below expectations on numerous occasions post-financial crisis. We expect a modest uplift in 2022. Labour shortages driving the substitution of machinery, sustainability driving investment into renewables, de-globalisation driving investment in supply chains and tax incentives all point to more capex at the margin, but we expect caution to prevail in the C-suite. We do not expect leverage to increase because of higher capex as earnings and free cash flow should fund much of the investment.

High Yield Corporates Over Investment Grade

We expect default rates to fall in 2022 and stay low reflective of the strength in corporate risk profiles supporting high yield (Display 2). With investment grade more sensitive to risk free rates, we prefer the shorter maturity and greater yield offered by owning lower rated corporates.

 
 
 
DISPLAY 2: Default rates are expected to fall in 2022, reflecting corporate strength
 

Source: Moody’s Annual Default Study

Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass.

 
 

Emerging Market Corporates Over Developed

Since the start of the pandemic emerging market corporates have improved credit metrics through discipline and patience, fortifying balance sheets and conserving liquidity. The regional economies are sensitive to vaccination rates as well as capital flows that are in turn sensitive to relative growth rates. Looking to 2022 we expect emerging economies to benefit from a global reopening underpinned by increased vaccination, greater immunity, and a political shift to support regional growth. Against this backdrop we see value in the extra yield offered by emerging corporates but would look to active management given the geopolitical risks in key geographies and the social agendas that favour reducing inequality.

Value in Companies with Improving Sustainability Metrics

2021 saw investors continue to focus on sustainability as a core objective. As ESG data becomes more standardized and sustainability portfolio guidelines more prescriptive, we expect the demand for issuers and sectors that meet sustainable criteria to increase at the expense of laggards. One area of opportunity is companies that are demonstrating positive momentum in improving their sustainability profile, in response to engagement. We expect these companies to benefit from improving ESG data in 2022.

Market Technicals Mean Rangebound Trading in 2022

2022 will likely see supply broadly inline with 2021, given our expectations of no irregular spike in M&A or capex led issuance. At the same time, we expect demand to be buttressed by two competing factors: 1) a generally less easy monetary policy from central banks and QE programs, and 2) an ever-ageing demographic where pension funds need to rebalance to match liabilities more closely. In this environment, we expect volatility induced by technicals to be an opportunity for the active investor in 2022.

Conclusion

Corporates are in good shape going into next year and are expected to work for all stakeholders, including the bondholder. Valuations have cheapened in recent weeks reflective of increased uncertainty and some market indigestion, creating opportunities in the credit market. Historically the early stages of the expansionary economic phase have experienced credit spreads that trade in a range, which is our base expectation for 2022. Moreover, the themes discussed in our outlook, including the continuation of M&A, slightly less supportive policy, and the continued focus on sustainability momentum by investors, could result in greater spread dispersion between issuers.

As a result, we are focused on two dimensions for the year ahead. Firstly, we are biased to own default risk over credit beta risk, particularly in pockets such as High Yield and Emerging Markets, and plan to actively trade on market technicals. Secondly, we continue to focus on bottom-up security selection to capitalise on spread dispersion opportunities.

 
 

RISK CONSIDERATIONS

There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). ESG Strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance.

 
richard.ford
Managing Director
Global Fixed Income Team
 
joseph.mehlman
Managing Director
Global Fixed Income Team
 
richard.lindquist
Managing Director
Global Fixed Income Team
 
warren.mar
Managing Director
Global Fixed Income Team
 
tom.wills
Managing Director
Global Fixed Income Team
 
jim.caron
Managing Director
Global Fixed Income Team
 
 
 
 

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