The Impact of Rising Government Bond Yields on Global Credit

As bond yields continue to rise, credit has been more of a passenger than the driver of recent market volatility.

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Andrew Sheets: Welcome to Thoughts in the Market. I'm Andrew Sheets, Morgan Stanley's Head of Corporate Credit Research. 

Serena Tang: And I'm Serena Tang, Morgan Stanley's Chief Global Cross-Asset Strategist. 

Andrew Sheets: And on the special episode of the podcast, we'll discuss Morgan Stanley's updated cross-asset and corporate credit views. It's Friday, October 6th at 3 p.m. in London. 

Serena Tang: And 10 a.m. in New York. 

Andrew Sheets: Before we get into our discussion, let me introduce Serena Tang as Morgan Stanley's new Global Cross-Asset Strategist. Serena has been working with me for the last 15 years and together we initiated our cross-asset effort nearly a decade ago. Serena was responsible for building the team's investment framework, specializing in multi asset allocation, portfolio optimization, and long run capital market assumptions. So I can confidently say that Morgan Stanley's cross-asset effort is in very capable hands. As for me, I'm now Morgan Stanley's Head of Corporate Credit Research, but I'll continue to host my colleagues as we look forward to bringing you key debates from across asset classes and regions. So, Serena, welcome and let's jump right into what's going on in markets. Over the last several weeks, as everybody in the U.S. has returned from summer, the debate among Morgan Stanley's economists and strategists is centered on two main issues, the outperformance of the U.S. economy and the underperformance of China's economy, as well as the spike of government bond yields, especially at the longer end of the curve. So where has this left our views across asset classes? 

Serena Tang: Yeah, yields and real yields have indeed moved a lot higher in a very short amount of time, you know, on that narrative that rates will stay higher for longer. And I would say that, you know, while the market has been going against our current call for government bond yields to fall over the next 6 to 9 months or so, we’re steadfast on our preference for high quality fixed income over risk assets like global equities, like high yield corporate bonds. And the reason really comes down to how higher real yields mean the discount rate for equities is also higher, leading to lower stock prices. And we've kind of seen this over the past few weeks or so. I think this is especially true in today's environment where the rise in yields and the rise in real yields isn't really driven by a rise in growth expectations, which you know traditionally have been great for equities thinking about future growth. But rather today's move in yields is really much a function of what the markets think the Fed would do over the coming few months. And all this largely explains the nearly 9% selloff we've seen in global equities since the start of August. But Andrew, you know, such dynamics must also be very similar in the credit world. In your view, how do rising government bond yields affect your outlook for global credit? 

Andrew Sheets: So I think credit finds itself in a pretty interesting place as bond yields have risen. You know, I would safely say that I think credit as a passenger in recent market volatility, it's not the driver. And, you know, if I think very simply about why bond yields have been selling off and there are a lot of different theories of why that's been happening, maybe a simple explanation would be that bond yields offer pretty poor so-called carry, a government bond, a ten year government bond yields less than just holding cash. They offer poor momentum, they're moving in the wrong direction and they have difficult technicals, i.e., there's a lot of supply of government bonds forecast over the coming years. And across a lot of those metrics, I do think credit looks somewhat better. Credit yields are higher, that carry is better. Credit compensates you more for taking on a longer maturity corporate bond, which is the opposite of what you see in the government bond market. And as yields have risen, companies have looked at those higher yields and done, I think, a very understandable thing, they are borrowing less money because it's more expensive to borrow that money. So we've seen less supply of corporate bonds into the market, which means there's less supply that needs to be absorbed and bought by investors. So credit can't ignore what's going on in this environment and we're broadly forecasting this to be worse for weaker companies, as the effect of potentially slower growth and higher rates we think will weigh more heavily on the more levered type of capital structure. But overall, I think within this kind of challenging environment, I think credit has been an outperformer and I think it can remain an outperformer given it has some advantages on these key metrics. 

Serena Tang: So you touched on lower quality companies. One of the very interesting forecasts from your team is that we still think default rates can go higher over the next 12 months. Now, how do I square this with everything that you just said, but also our U.S. economics team’s continued forecast for a soft landing? 

Andrew Sheets: It's a great question. I'd say our default forecast, which is that US default rates rise to a little bit under 5% over the next 12 months, is quite divisive. I’d say there's a group of investors who say, well, it doesn't make a lot of sense that default rates would rise given that our base case does call for a soft landing of the US economy, no recession. And another group that says, well, that seems like too low of a default rate because interest rates have just risen at one of the fastest paces we've seen in 150 years. Of course, that's going to put stress on weaker companies. And I guess we see the markets splitting the difference a little bit between that. I think the fact that you are seeing a clearly outperforming US economy, I think that does really reduce the risk of an above average default rate. It would be very unusual to see an above average default rate with anything like what we're forecasting in our base case economically. And then at the same time, you do have, thanks to the low rates we're coming from, an unusually large share of borrowers who borrowed a lot relative to the amount of income that they generate because they could do that at lower interest rates, and now that's going to be a struggle at higher interest rates. So I think the combination of those two factors gets you something that's in the middle. I think you do have a more robust than expected US economy, but you do have this tail of more heavily indebted issuers that is just, I think, going to struggle with the math of how do you pay for that debt when the interest rate is effectively doubled from where it was just 18 months ago? 

Serena Tang: And you described just now our credit being in the middle, so to speak. And, you know, being in the middle is much better than what we're projecting for equity returns, and hence one of the reasons we like high quality credit and we like high quality bonds. But then my question to you is, what might the market be missing right now? But also importantly, what do you think we might be wrong? 

Andrew Sheets: So I think there are a couple of important things to follow. I think there has been over the last several years an advent of alternative forms of capital, some of this is kind of rolled up into the general classification of private credit. But, you know, there have been a lot of new entrants, new investors who are willing to lend to companies under nontraditional terms. And I think it's a big open question around, does that presence of additional investors actually make defaults a lot less likely because there's a new outlet for companies that need to raise funds from this new investor pool, or does that pool not have that effect? And if anything, maybe it is a source of some additional risk. It's a group of lending that's hard to observe by design, by its nature. I think another important thing to watch will be what do companies do? Part of our thinking on the research side is that companies will view current yields as expensive and they will react like any actor would act. When it's more expensive to borrow, they will borrow less. They will try to improve their balance sheet and maybe in the process they'll buy back less stock or do other types of things. That might be wrong. You know, we might see a different reaction from companies. Companies might view that debt cost as different. Maybe they view it as more reasonable than we think they will. So at the moment, we're thinking that companies will view that debt is expensive and respond accordingly and do more bondholder friendly things, so to speak. But we'll have to see. And we could be wrong about how corporate treasurers and management are thinking about those trade offs. 

Andrew Sheets: Serena, thanks for taking the time to talk. 

Serena Tang: As always, great. Speaking of you, Andrew. 

Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.