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Credit markets are experiencing lower risks of recession, and profits may challenge that

US high-yield corporate debt markets may be undervalued against recession risk even as Treasury bonds and macroeconomic indicators reflect rising growth concerns, but that may be tested soon as corporate earnings are expected to worsen.

Leveraged loans and high-yield corporate bond prices have both retreated from record lows reached early this year as interest rates increased and spreads widened at record rates, but they still reflect a relatively rosy economic outlook.

“Credit spreads are too narrow, they don’t adequately reflect recession risk. The other models we use, whether it’s the yield curve or solid macroeconomic data, are more bearish,” said Matthew Misch, head of credit strategy at UBS.

UBS said spreads on high-yield or “junk” bonds and leveraged loans indicate a recession probability of 25-30%, while other models show a 55% drawdown probability. Leveraged loans and junk bonds are high-risk corporate debt.

Loans typically have floating rate payments and a secured claim to the company’s assets in the event of default, while bonds are unsecured and often have fixed rates.

Their borrowing rates have been constrained by strong liquidity while default rates are close to historical lows and are not likely to rise significantly in the near term.

Earnings were better than expected in the second quarter on average, but higher rates and slower growth are expected to make a bigger impact on earnings soon, which could lead to a rating downgrade and increased default risk.

said Srikanth Sankaran, head of US and European credit at Morgan Stanley.

Many fund managers say they are concerned about the outlook. Risks are likely to first appear in loans, which have seen rapid growth, higher leverage, deterioration in credit quality and lower credit terms in recent years, even as the high-yield bond market has seen an overall improvement in credit.

“Credit quality in the loan market today is lower than in the past,” said Michael Chang, head of high-yield credit at Vanguard, adding that “while valuations have improved, risks remain high.”

The risk is not evenly distributed, with many citing the heavy “B” leveraged loan (LBO) segment, the second lowest before default, as posing the greatest concern.

Scott MacLean, director of leveraged loans at Alliance Bernstein, sees the risks of a large number of downgrades of companies’ B rating to CCC, the lower range of the rating, as they face higher borrowing costs and lower profits.

The fund manager believes that this could largely eliminate all free cash flow for an unprotected average B issuer. “There is a moderate amount of concern reflected in loan rates currently, although we don’t think the market has completely wrapped its head around the fact that many companies simply cannot pay the higher interest costs, especially with the moderation of demand,” he said. .

pockets of opportunity

While expectations are fraught with risk, more bifurcation of credit performance also creates opportunities. Anders Persson, chief investment officer for global fixed income at Noufen, said the company is “moving towards” higher-yield bonds and leveraged loans, with a focus on better “BB” and B-rated companies, even if it “expects more fluctuations.”

He noted that while the prospects for a “soft landing and a moderate recession” had already been identified, a hard landing had yet to occur. Vanguard’s Zhang continues to see opportunities in sectors that benefit from rebounding demand as the economy reopens from COVID lockdowns, such as airlines, accommodation and gaming.

Despite this, the company maintains a defensive attitude and a quality bias. AllianceBernstein’s MacLean notes that at current spreads in the 500 basis point range according to the JP Morgan Leveraged Loan Index, loans could see a default rate of 8% for each of the next five to six years.

This is “much higher than any extended period in history, and still has the potential to generate more returns than money market funds, providing a strong risk-return profile for long-term investors,” he said.

The next few quarters may determine if the market is still ripe for credit picking, or if there is a further deterioration in prices and credit quality across the board.

For now, the credit market is still comfortable with the fundamentals in place and the slow pace of decline. “I think the next two earnings seasons will be a critical test of this hypothesis,” said Morgan Stanley’s Sankaran.

(Editing by Alden Bentley and Chizu Nomiyama)

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