Selective Value in Credit and Munis
August 9, 2023
An 11th US interest rate hike now under the Fed’s belt, its forward rate guidance is now reaching the terminal rate of this monetary cycle. The ongoing fall in inflation coupled with tight, but weakening, labor markets are likely to lead to range bound credit yields in the near term. While this is also likely to push out rate cuts to 2H 2024, locking in yields, extending duration and selectivity on credit quality are key.
Investment Grade (IG) Credit has continued to witness tight credit spreads, and a small rise in corporate defaults but well below historical averages. While a ‘soft’ or ‘no’ landing becomes more likely, credit strength has also been a function of large amounts of debt refinancing at lower fixed rates, prior to Fed rate hikes. Banks, both in the U.S. and Europe, continue to offer better spread differentials than non-financial sectors. The greater concern in credit is the pending maturity wall in IG vs. high yield rated corporate debt. While IG maturities remain consistent over the coming 4 years, high yield credit sees +150% growth in maturities from 2023 to 2024 and another 60% growth into 2025. The prospect of Fed rate cuts will likely still not be a sufficient buffer during this period, as interest costs have already begun to spike. Collateralized Loan Obligations (CLOs) now offer a higher relative value, but only at the highest rated tranches. Selectivity in credit risk has become paramount – as downgrades and higher interest costs can likely shun both fixed and floating rate borrowers from inclusion in investment vehicles (e.g. CLOs) and thus prompt greater defaults.
Municipals, on the other hand, continue to offer attractive value, especially with a barbell approach. Tax equivalent yields remain especially attractive through the front and long end of the Muni yield curve. While the belly of the Muni curve has inverted, a rarity for the Muni market, the yield curve remains upward sloping. Munis have continued to see credit rating agency upgrades throughout the pandemic and remain well positioned for a return of investor flows back to the Muni market.
A tight US labor market and continued falling inflation create an environment for range bound yields as the Fed assesses its policy path through the fall. This provides ample time to capitalize on the short end of the credit curve and out of short duration cash instruments. Proactive extension in duration and selectivity in credit is paramount in this environment, in the context of an eventual normalization of the yield curve.
More than 50% of S&P500 companies have already reported in the U.S. Q2 earning season. 80% of the firms registered a positive EPS surprise. The question for most investors now, is whether the earnings growth results will keep driving positive global equity market dynamics for the 2nd half of the year.
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