Are central banks behind the curve on inflation?
I think central banks have taken robust action in terms of raising rates but there's an element of inflation that's been structurally stickier than anticipated. When you break it out in terms of markets, I think the Fed was on the front foot initially; even though you're seeing the policy action slow down as of the last Fed meeting, there was still a hawkish tone to it to keep that element open.
In Europe that stickiness with inflation is also there and persistent. I think that it will remain higher for longer as well. But again, the central bank in Europe is taking an aggressive stance while trying to find the right balance between the short-term impact of exogenous factors such as the war in Ukraine versus managing some of the long-term issues of inflation.
What do you see as the causes of the persistent inflation?
I think there are areas which may have an impact on corporate and consumer spending, more so in the medium term than the short term. For instance, we've seen this in commodities with supply chain lead times and the impact of globalisation. Historically globalisation has been positive as it's improved trade and brought down costs. But given the issues in China and Ukraine, what we've learnt is globalisation can have negative effects on trade and lead times that translate into higher inflation.
The other major area is the labour market. Although flexible, there's been a structural shortage in labour across many sectors, both in Europe and in the US. The obvious ones that stand out are healthcare and in services generally but you're also seeing it in many other areas.
I think the fact that corporates are having more difficulty filling up roles while keeping payrolls under control is a challenge.
The question for corporates is if growth is slowing, how do they find the right balance to make sure they retain the right talent and recruit for new openings but at the same time keep equity investors satisfied that they can still hit their profitability targets? I think that's going to be a challenge as a function of inflation.
With rising rates, what is the outlook for companies that need to refinance in the next few years? How did we get here?
One of the benefits of the post-Covid fiscal and monetary policy was the record low-interest rate environment. It allowed corporates across the board, irrespective of ratings, to refinance their debt and as a result we saw record issuance in 2020 and 2021. However, pre-Covid there was a concern that we were towards the late stage of the credit cycle and refinancing risk was increasing. When the pandemic hit, that was reflected with spreads increasing materially, not only because of what was going on but because there were questions as to whether companies could refinance their debt due within the next 18 months. As a result, policymakers needed to intervene quickly, which they did. What we saw was that the refinancing wall was extended from 2022/2023 to broadly speaking 2025 and beyond.
I think now we're back in the stage in the credit cycle where companies need to start revisiting and refinancing their debt maturities, which are now due from 2025 and 2026.
The next 12 to 18 months are going to be very important for high yield, particularly the lower-rated high yield companies. Now we're talking about a cost of debt which has gone up 2 to 3 times since 2020.
What does this mean for refinancing?
There will certainly be variation in terms of the options available to the different types of companies that are out there. I think there will be opportunistic types of refinancing between now and this 2025 maturity. But there are good and bad ways to do opportunistic refinancing.
We've seen companies in the healthcare, transport and service sectors who have had creditor-friendly means of extending debt through asset sales or a friendly exchange programme. That keeps the bondholders and loan investors better protected, extends maturities, and gives these higher-quality companies time to manage the new capital structures.
However, some businesses use refinancing opportunistically in a negative way. That's a function of weak documentation and a revaluation of the enterprise values of these businesses. I think these companies pose a substantial risk for investors.
Historical loan recovery rates have been 60% to 70%. But when you look at companies now which are fundamentally deteriorating and are trading at stressed levels, these loans can be priced somewhere between 20% to 50%, much lower than the historical recovery rates for loans. This is due to their inflated level of leverage, revised market expectations of enterprise value, and weaknesses within their documentation. The key for investors is to spot these issues and differentiate the good companies from the bad ones.
Given the risk in high yield companies, why not stay in investment-grade bonds?
The high yield market has changed a lot structurally. If you go back 15 or 20 years, BB credits made up less than 50% of the overall high yield market. Now it's two-thirds of the market and CCCs are less than 10%. The composite has changed quite significantly and during the pandemic we had billions of dollars in downgrades from investment grade, creating fallen angels. That further changed the scope of the high yield market.
This skew towards higher quality and this BB category includes former investment-grade bonds, which are quite comparable to the lower-rated investment-grade companies.
From a spread perspective, there'll be quite a few times when you'll find opportunities in the market where the spread pick-up in the higher-rated high yield market looks very attractive versus parts of the investment grade structure. I think the risk of default in this higher-quality high yield is materially lower and you're still getting paid reasonably well. The second element is how the yield curve is positioned. The front end is still paying quite a bit. You can potentially get paid for not that much duration risk and still pick up a reasonable amount of yield.
How are you positioned within your multi-asset credit strategy given the market outlook?
I think the benefit of being able to invest across asset classes enables you to find relative value. One of the areas I see potential value is short-dated leverage loans. The benefit of those is you get decent carry, you're not exposed to duration risk and some of the high quality loans trade below par so you get a bit of convexity on refinancing it because of the better quality.
Another place where we find some defensive characteristics is short-duration high yield. This is the same point I mentioned earlier; 6.5% to 8.5% potential yield opportunities and bonds coming due in 2 to 3 years. When you look at the curve, you're getting paid well up front, and this is the case even in the same companies relative to the back end of their curves without taking as much duration risk.
Going back to the investment grade component, I think there is possibly room to invest now. Some of the longer duration, high quality, low single A, high BBB, and longer duration investment-grade offer good value with 5% plus yields. If the rates environment starts to turn you also get some yield compression which gives you some good convexity.
Lastly, a different area which I find interesting is high quality investment grade within Collateralised Loan Obligations. I think it's an attractive place where you have a significant amount of collateral enhancement and subordination below, so you are well protected. You are potentially getting a very attractive carry for AAA paper, which looks very well-priced. You're not exposed to interest rates, so it fits well within the overall portfolio by giving you the right balance between high quality, low-interest rate exposure, and carry.
What would a good asset manager be doing right now versus a bad one?
I think it's really about fundamental analysis and stock picking. I think this is a market where you can pick the winners from the losers when you're selecting the right bonds and loans. Given an environment where rates are rising, credit defaults are starting to creep up, and given that recoveries are going to be more challenging, it's about finding the right names within the various asset classes. The key is to find the opportunities which give you that pickup while avoiding negative idiosyncratic risks that exist with those who may fail to refinance.
The value of investments and the income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested.
To find out more about Royal London Asset Management's range of investment solutions please visit www.rlam.com
This post is funded by Royal London Asset Management
For Professional Clients only, not suitable for Retail Clients.
This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change.
Issued in July 2023 by Royal London Asset Management Limited, 80 Fenchurch Street, London, EC3M 4BY. Authorised and regulated by the Financial Conduct Authority, firm reference number 141665. A subsidiary of The Royal London Mutual Insurance Society Limited.