Investors in today’s credit market must be more discriminating to get the most of opportunities now, the author of this article argues. 

The following article is from Al Cattermole, senior fixed income portfolio manager at Mirabaud Asset Management. The editors are pleased to share these insights; the usual editorial disclaimers apply to views of guest writers. Please comment and contribute to conversations: email tom.burroughes@wealthbriefing.com and amanda.cheesley@clearviewpublishing.com

The first half of the year reinforced the case for corporate credit, but it also made the market more divided. The biggest change has been the Iran conflict and its impact on inflation, growth and earnings expectations, primarily through higher oil prices. This improved the outlook for energy and some parts of chemicals but created pressure for companies that use oil or energy as an input cost which they cannot pass through.

This is where selection matters. We are looking closely at whether higher energy prices create a margin squeeze, a demand shock, or both. The risk lies in companies facing higher input costs at the same time as weaker end-market demand. The full impact is not yet visible, as the Q1 reporting season only captured the early stages of the conflict, when many companies and consumers still expected a quick resolution.

AI has also become a more important topic for credit. AI investment and data centre construction continue to support US growth, while fears of a collapsing labour market have eased into more of a “no hiring, no firing” environment. At the same time, AI is challenging parts of software, media and technology where business models or terminal values are being questioned.

Overall, earnings momentum has improved despite the volatility. Outside the sectors most directly affected by oil prices, companies continue to deliver resilient results.
 

Income remains the strongest reason to own credit 

The strongest case for credit remains income. Spreads may not fully compensate investors for downside risk, but total yields remain attractive, with high yield at around 7 per cent and investment grade above 5 per cent in US dollars.

In a non-recessionary environment, that income can continue to do a lot of the work. Investors can potentially earn 7 to 9 per cent per annum from high yield through coupon income, with relatively modest movement from rates or spreads if total yields stay range bound.

Defensive, developed market high yield is a core fixed income building block. It can provide a stable source of income through time, while allowing investors to take more selective risk elsewhere. Current yields are not at an extreme in either direction, but they still justify an above-neutral allocation.
 

Quality matters

Investors should stay selective and avoid the most vulnerable parts of the market. We remain underweight CCC-rated credit because today’s environment does not favour the lowest-quality issuers.

CCC companies often need stronger revenue growth to support their capital structures, but the market now faces a weaker growth backdrop. Many also remain exposed to higher-for-longer interest costs, particularly where they have floating-rate debt or refinancing needs. At the same time, raw material inflation, weaker demand and structural disruption are putting additional pressure on margins in some sectors.

Housing-related sectors highlight the risk. High mortgage rates have reduced housing transaction volumes and created pressure in areas such as building products. In software, media and parts of tech, AI is challenging business models and terminal values. For us, this is not an environment to reach aggressively into the lowest-quality part of the market.

 

Cause for caution

Investors should be cautious on Europe, CCC credit and very long duration. Regionally, Europe is more exposed to higher energy prices because it imports more oil and is more dependent on Russian or Middle Eastern gas. While US growth expectations have improved, European growth forecasts have come down. The UK shares some of Europe’s vulnerabilities: it is a large energy importer; it entered the crisis with a more fragile economy than the US and faces additional political uncertainty.

By sector, investors should be cautious on housing, distressed media, software, pure retail, consumer discretionary and travel. The common threads that impact these sectors are vulnerability to higher rates, pressure on discretionary income, weaker demand and structural disruption. We view the US consumer as a particular area of vulnerability, given high interest rates, elevated food and gasoline inflation, low savings and high personal debt levels.

We are also cautious on very long duration. Inflation has not risen as much as feared so far, and the interim US-Iran deal has reduced the immediate escalation risk. However, energy markets remain vulnerable while traffic through the Strait of Hormuz normalises and shipping backlogs clear, and the second round of inflation effects have yet to be seen. Fiscal deficit concerns and sharp moves in long-dated government bond yields also support a conservative duration stance.

 

Duration discipline

A focus on corporate credit rather than sovereign debt remains important. We are conservative on duration and underweight Europe. By sector, we see opportunities in financials, which benefit from a higher-rate environment, and energy, where commodity prices are expected to remain high as well as defensive exposure through consumer goods and telecoms.

There are opportunities in corporate credit if volatility were to drive meaningful spread widening, especially if markets priced in a weaker growth outlook too aggressively. We also see opportunity in duration as markets began pricing in rate hikes. When markets price in two cuts, investors should want to be shorter duration; when they price in two hikes, they should be more willing to add duration, because the market may have moved too far.

In our global strategic bond strategy, high yield exposure stands at around 30 per cent, versus a maximum of 40 per cent. That level fits the current yield environment while preserving dry powder to add if valuations improve. If high yield yields moved towards 8.5 to 9 per cent, we would be ready to lean further into that exposure.

About the author
Al Cattermole, fixed income portfolio manager and senior analyst, joined Mirabaud in November 2013, from Goldbridge Capital Partners where he was responsible for corporate credit research. Cattermole,who previously covered global corporates as an executive director at JP Morgan Asset Management and as an analyst at ECM, started in credit markets at the Bank of England in 2002. He holds a BA in economics from the University of Durham and is a CFA Charterholder.