Vishy Tirupattur: Corporate Credit Faces New Challenges

Like many markets, Corporate Credit has faced a rocky start to 2022. For investors, understanding the difference between default and duration risk will be key to positioning for the rest of the year.

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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Global Director of Fixed Income Research. Along with my colleagues bringing you a variety of perspectives, I'll be talking about corporate credit markets against the background of policy tightening and heightened geopolitical tensions. It's Monday, February 28th at 10 a.m. in New York. 

It's been a rough start for the year for the markets. Central banks' hawkish shift towards removing policy accommodation, the significant flattening of yield curves that followed, rising geopolitical tensions, fading prospects for fiscal support, and growing concerns about stretched valuations have all combined to spawn jitters in financial markets. Corporate credit has been no exception. After two years of abundant inflows, the narrative has turned outflows from credit funds in conjunction with negative total returns. These outflows conjure up painful memories of 2018, the last time the credit markets had to deal with substantial policy tightening. 

Let us focus on the source - sharply higher interest rates and duration versus credit quality and default concerns. Consider leverage loans, floating rate instruments that have credit ratings comparable to high yield bonds which are fixed rate instruments. 

Since the beginning of the year, high yield bond spreads have widened almost three and half times more than leverage loan spreads. If you limit the comparison just to fixed rate bonds, the longer duration investment grade bonds have significantly underperformed the lower quality high yield bonds. Clearly, it is duration and not a fear of a spike in defaults that is at the heart of credit investor angst. 

My credit strategy colleagues, Srikanth Sankaran and Taylor Twamley, have analyzed the impact of rate hikes on interest coverage ratios for leveraged loan borrowers. This ratio is a measure of a company's ability to make interest payments on its debt, calculated by dividing company earnings by interest on debt expenses during a given year. The key takeaway from their work is this - What matters more for interest coverage is the point at which higher rates become a headwind for earnings growth. Loan interest coverage ratios have historically improved early in the hiking cycle as interest expenses are offset by growth in earnings. 

I draw comfort from the evidence that as long as earnings growth holds up and does not turn negative, corporate credit fundamentals measured in interest coverage ratios are positioned well enough to withstand our economists base case of six 25 basis point rate hikes in this year. 

While credit fundamentals look fine, valuations are not. Since the beginning of the year, we have seen spread widening, the pace of which has picked up in the last couple of weeks. So, we still prefer taking default risk over duration and spread risk. The risk to this view has increased in the last few weeks. Specifically, if central bank reaction to the heightened geopolitical risk is to control inflation at the expense of growth, lower quality credit may be more exposed. 

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