There’s no nice way to put it: 2022 was a miserable year for credit. There were not only fundamental changes in the market, but a war started in Europe. What does that market look like this year, and what should a credit investor do?
Last year we saw fundamental changes in the market, with central banks switching from stimulus and negative rates to tightening policies and rate hikes, Russia starting a war in Ukraine, and inflation shooting up dramatically. While some sectors did reasonably well from the credit investor’s point of view, plenty of others performed poorly, the hardest hit being real estate.
While there is still some volatility ahead, 2023 looks, thankfully, a lot brighter. Here’s what to expect in credit and a few interesting areas to keep an eye out for.
Pricing in the recession
Markets and companies have already started adapting to the new environment, meaning that many of the shock factors are already behind us. However, this winter will be tough in Europe, thanks to the constraints in energy supply and historically high energy prices. The central banks will keep tightening their policies. All this considered, it’s safe to assume that volatility will stay elevated this year.
Given how hawkish the Fed and European Central Bank are, the economies on both sides of the pond are going to slow down in 2023 and most probably face recession. The question now is how deep and long-lasting it will be.
The messages from ECB have been clear about upcoming rate hikes. However, we can already see dispersion within the Eurozone, especially Italy being increasingly vocal about the negative consequences of higher rates. We will likely see several hikes if the macroeconomic data still shows inflation way above the central bank’s mandate. However, much of the tightening is already priced in, with the shorter end of the yield curve at almost 2.6% (German 2-year) and spreads already pricing in mild recession for 2023.
Therefore, spreads have tightening potential if we manage to avert a full-blown recession. At the same time, such an outcome could pose a risk for longer-duration fixed income, given that the longer end of the yield curve has remained low at around 2.1% in anticipation of upcoming central bank easing. All this considered, short-duration corporate bond market is particularly well positioned for 2023.
Strong fundamentals are a credit investors’ silver lining
The good news in this volatile environment is that companies have very low leverage and credit fundamentals are much stronger than before the pandemic. From the perspective of credit fundamentals, there has rarely been such a strong entry point to a potential recession as what we currently have.
In the long term, credit fundamentals matter the most for yield spreads, which now are at the same level as during the first Covid-19 wave in the late summer of 2020, reflecting the amount of uncertainty and risk priced in.
Issuers are already accepting that the time of free money is over, and companies are no longer avoiding issuing at higher yields. Therefore, we expect issuance to be healthy, offering many good opportunities for a selective long-term investor. Here are a couple of things to look for in 2023:
• The Nordic unrated primary market: Activity will pick up as companies start to refinance their outstanding bonds proactively. Unrated bonds typically offer 50 to 150 basis points of excess spread compared to similar credit profile rated crossover peers, thus providing an opportunity to enhance total return potential without taking additional credit risk.
• Short maturities: Here, the time is on the investor’s side. Over time, investors will experience a pull-to-par effect in the absence of defaults. While the all-in YTM was at around 1.3% at the start of 2022, at the end of December the Short Corporate Bond fund was priced at a very high yield level of 5.51%, offering a considerable buffer for further rates and/or spread moves. When the true underlying maturity of the portfolio is low together with low duration, the carry (i.e. yield generated during the year) provides very high compensation for credit risk. Significant part of this carry return is coming from price appreciation of bonds, when passage of time is pulling bond prices towards 100 (i.e. "par”).
All in all, credit investors should keep their eyes on the horizon and patiently enjoy the high carry return in 2023 rather than worry about short-term volatility. Evli’s credit funds are well-positioned to profit from the higher-yielding environment and strong credit fundamentals.
