Credit Outlook Q2 2023: Gradually, Then Suddenly

We expect dispersion to accelerate as growth slows and winners and losers bifurcate, so favour remaining selective in our credit exposure.

All of the classic signs of late-cycle euphoria are on display: accelerating inflation, rising interest rates, over-payment for assets, a glut of issuance. So how should high yield investors prepare themselves if the credit cycle ends?
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Much recent fearmongering about banks ignores the value of their deposits. We explain why that is at best inconsistent – but also not cause for complacency.
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Bonds become more volatile than equities; checking on China’s reopening; and investors’ search for quality.
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With loan and high-yield issuance in the doldrums, we explain why convertible bonds may be becoming more attractive to companies and investors alike.
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Concern about bank solvency began focused on the US, but the selloff extended to Europe and Japan too. Are the worries justified?
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Higher yields but the potential for further spread dispersion in the global investment-grade index make credit selection crucial, in our view.
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Bond markets struggled with rate hikes in 2022. Are they ready for what comes next?
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We have been speaking about the end of the credit cycle for some time, but the speed of the developments in the first quarter of this year has left us pretty surprised. A sector that was seen as healthy – banking – has come under pressure largely through poor risk management at a few institutions, which has led to broader concerns across the banking industry. It does show that trying to time the end of the credit cycle can be challenging, as it can occur “gradually and then suddenly”.

So what are the tell-tale signs of the end of the credit cycle?

Sign Increased volatility Higher interest rates Financial instability Economic slowdown
View Incomplete In progress Incomplete In progress
Comment We are seeing a material increase in rate volatility, but less so in risk assets, with both credit and equity volatility remaining well contained. The world’s major central banks have already hiked rapidly, and many have expressed an intention to go even higher to tame inflation. After the wobble in mid-March, an eerie calm has re-emerged across the market. The minutes of the Federal Open Market Committee’s March meeting state its staff expect a mild recession starting later this year and below-potential growth in 2024.1

The recent stress in the banking system may accelerate the move into the end of the economic cycle, as it is likely to lead to slowing growth in bank lending. In combination with higher rates, such tighter financial conditions are in turn likely to create a more challenging backdrop for future economic growth. Looking at housing starts, consumer confidence, PMIs, and the continued inversion of the yield curve also continue to point to some uncertainties going forward. It is therefore perhaps not surprising to see small-business optimism below even the Covid lows (Figure 1).

Figure 1. NFIB Small Business Optimism Index

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Source: Bloomberg and National Federation of Independent Business; as of 31 March 2023.

How should investors position for this? One option is to maintain a higher-quality bias as spreads in investment grade, particularly in Europe, continue to remain elevated relative to history (Figure 2). Additionally, while not cheap on an absolute basis, the lower-quality parts of the credit market are offering value relative to equities (Figure 3). There are certainly pockets of opportunity across most markets, in our view, although we do think that investors are better served to remain selective as dispersion is likely to accelerate as growth slows and winners and losers bifurcate.

Figure 2. Credit Spread Percentiles, December 2022 Versus March 2023

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Source: Man GLG, JP Morgan, ICE BofA and Bloomberg; as of 31 March 2023.

Figure 3. High Yield Spread Versus S&P 500 Risk Premium

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Source: Man GLG and Bloomberg; as of 31 March 2023.

Q2 2023 Outlook

At Man GLG, we have one overriding principle: we have no house view. As such, portfolio managers are free to execute their strategies as they see fit within pre-agreed risk limits. Keeping that in mind, the outlooks below are from the different credit teams at Man GLG.

Global Investment Grade: With all-in yields remaining high, we think that investors can continue to benefit from an allocation to investment-grade credit. Investment grade’s response to the market volatility experienced in mid-March also shows the benefits that duration can offer investors. With terminal rates in the US reaching circa 5%, we still think that interest rates offer attractive diversification for investors. Additionally, the recent widening has once again created value for investors with a strong preference for opportunities in GBP and EUR. We continue to keep a wary eye on the US as the recent bank fragilities are likely to increase the chances of a hard landing over the coming quarter. At the same time, valuations remain more expensive than in Europe.

Although we are constructive on the broader market, we believe dispersion between sectors, geographies and single names has created deep value opportunities for bottom-up investors to seek to generate strong excess returns next year. For us, value remains in Europe with a focus on financials companies, which remain in a robust position compared with their US counterparts (Figure 4). Credit Suisse was an outlier, in our view, not a precursor of things to come. Although value has started to emerge in non-financial cyclicals, we continue to take a more cautious view on them. As growth slows, we believe a higher risk premium will need to be attached to these sectors as demand slows and profitability weakens. All in all, we see dispersion increasing as growth slows and believe the backdrop creates an attractive opportunity set for high-conviction and active fund managers.

Figure 4. The Yield Differential Between Financial and Non-financial Corporate Bonds is at its Largest Point Since the Global Financial Crisis

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Source: Man GLG, ICE BofA and Bloomberg; as of 18 April 2023.

Global High Yield: Banking fragility in and of itself should not be a surprise; we think it is just one of the consequences of the tighter monetary policy regime that we are experiencing. We certainly believe that more pressure points will arise as financial conditions tighten. We have been speaking about this for some time, and believe that we are at the tail end of the credit cycle. The natural consequence of higher rates is lower growth, with a lag. The pressure that banks are currently facing is likely to accelerate the end of the credit cycle, as it would be difficult for banks to lend aggressively while they are seeing deposits fly out the door. We expect the pressure to be felt more acutely in the US relative to Europe, where banks retain much better fundamentals alongside better regulatory oversight.

We remain optimistic about the stock-picking environment but believe that caution on pure credit beta is warranted with spreads back to median levels. On a regional basis, we continue to maintain a preference for Europe over the US as we feel that the latter remains buffeted by expectations of a soft or no landing in the short term. On a sector basis, we have a strong preference for companies with pricing power and focus on consumer staples, healthcare and gaming. Additionally, we have a strong preference for secured paper heading into a growth slowdown. Finally, we continue to watch a number of special situations and stressed/distressed opportunities – it is notable that €96 billion of European high yield trades at spreads above 700 basis points2 – and would expect these opportunities to pick up materially as growth continues to falter.

Emerging-Market Debt: The turmoil in the banking sector has made the job of taming still stubbornly high inflation meaningfully harder. At odds with the rate cuts priced in by the market amid the crisis, the Federal Open Market Committee confirmed at its March meeting that inflation remained the top priority. The recent oil production cut announcement by OPEC+ contributed another layer of uncertainty to the global economy by adding to inflation pressures both in developed and emerging markets. In emerging markets, these headwinds join other strains such as capital outflows and restrictive access to more expensive primary-debt markets.

This leaves the emerging-market debt outlook between a rock and a hard place: calmer waters could prompt a hawkish repricing of US monetary policy, while further accidents would lead to a retreat of risk appetite. This asymmetric risk/ reward reinforces the case, in our view, for a higher emerging-market risk premium. Meanwhile, the B-rated (or lower) sector – where the probability of avoiding a default is closely linked to success in managing refinancing risks – is still widely unable to access funding markets. However, following the large tightening seen since October – and with spreads only slightly wider year to date – we think these risks are not yet being adequately priced. The same is true in currencies, following a 6.8% rebound in the last six-month period.3 Lastly, in emerging-market local rates, we remain concerned that some may trade more in line with risk assets than duration in the near term amid heightened volatility.

Emerging-Market Corporate Bonds: Valuations in emerging-market high-yield corporates have started to become more attractive, in our view, as the market begins to fear a hard landing. However, valuations remain only at median levels and we believe there remains more pressure to the downside, with valuations (particularly in investment grade) looking less compelling versus developed markets. Supply technicals continue to remain positive as issuance continues to run below long-term thresholds, but this is balanced with continued outflows from daily liquidity products. We remain selective on China property issues, seeing opportunities primarily in performing issuers. We continue to like sectors that we expect to benefit from a further reopening of China, such as consumer-driven areas like casinos and car rental. We also continue to like the fundamental story for India, with a preference for renewables, although valuations continue to reflect this. In Latin America, Brazil still trades poorly; while valuations are starting to look attractive, the overhang from government policy risk looms large. Mexico continues to benefit from near-shoring and remains solid fundamentally, in our view.

Convertible Bonds: After a very subdued 2022 overall, activity in the primary market picked up towards the end of the year and this trend has continued into 2023. Indeed, the market finds itself on a run-rate in line with average pre-pandemic volumes. Recent issuance trends have led to further diversification of the asset class, with the market being led in the year to date by more well established firms and those outside the technology space that has dominated over the past couple of years. For example, around one-fifth of new issue volumes this year have been in energy and energy-related sectors, while only a little more than 10% has been from the tech sector.4 On top of this, an increasing number of investment-grade issuers are launching deals in the convertible space, further enhancing the credit quality of the asset class.

Bond floors have in general remained stable and continue to support convertible valuations. There remain good opportunities in out-of-the-money convertibles, in our view, where investors can earn attractive yields while retaining a degree of upside equity exposure to companies with healthy balance sheets. Equally, while markets overall posted decent gains in the first quarter, the underlying equities of a large portion of the convertible market continue to trade at a large discount to past valuations. We believe this presents another favourable opportunity for investors, given the improved convexity profile of the convertible-bond asset class today.

Convertible Bond Arbitrage: As we enter the second quarter, credit has essentially been on a roundtrip to a flat performance, stocks are up and rates have tightened by around 40 basis points on the year. Convertible bonds have selectively lagged the rates moves, and have cheapened by 50-100 basis points (Figure 5). We began to add into this mini-dip in February and March. Absent large moves in the primary space, we expect convertible bonds to appreciate steadily in basis terms over the next few months, offset by continued apathy in equity volatility. We continue to favour high-quality busted bonds, shorter-duration gamma names, and reasonably priced vega/ volatility trades as portfolio anchors. Should the market falter, we expect credit hedges to provide reasonably priced defensive mitigation and we await further momentum in primary-market issuance.

Figure 5. Convertible Bonds Cheapened Significantly in the Middle of the Quarter Before Rallying

Source: Jefferies International Research; as of 31 March 2023.

Residential Mortgage-Backed Securities: Securitised products’ credit spreads in general, and specifically in residential mortgage-backed securities, have lagged the tightening we have seen in the most liquid credit markets. Agency and Jumbo mortgages are still significantly wide of where they fell during the SVB collapse in March, partially due to forthcoming price discovery from the sale of SVB and Signature Bank assets. Non-qualified mortgage securities have tightened more recently, on minimal deal flow, and while AAAs are around 15 basis points tighter than a month ago, the rest of the stack is 10-50 basis points wider.5 Single Family Rental credit is also significantly wider than a month ago, with little to no recent trading volume. Issuance may pick back up if rates continue to rally. Whole loans collateralised by residential property, which typically lag residential bond credit, have experienced less tightening and in our view continue to offer attractive spreads.

Many housing forecasts have been improving over the first quarter, driven by the continued lack of supply and the ripple effects of slowing inflation, reducing the cost to borrow and improving affordability. February brought the first month-on-month increase in home prices, of 0.8%, after seven consecutive months of negative national month-on-month numbers.6 We believe the uptick was partially driven by increased demand as rates rallied in February, and partially affected by the seasonality of homebuyer demand. While sales volume is down, housing permits rose in February after months of falling, and at February’s demand pace current housing inventory stands at only 2.6 months.7 These factors may help to stabilise home prices over the course of 2023.

Leveraged Loans: The first quarter of 2023 was a tale of two halves. Investors looked forward to saying goodbye to a tumultuous 2022 and the usual animal spirits were unleashed, hoping that the worst of 2022’s inflation was under control and a soft landing would be likely. The common January rally was indeed ferocious, with a 2.3% price gain and 2.8% total return in the Credit Suisse Western European Leveraged Loan Index (non-US dollar, euro-hedged) boosted by a limited primary schedule as only €4 billion priced (a year-on-year drop of 69%).8

But as is often the case, the enthusiasm runs out as excess cash is deployed and new news gives investors pause. The US January payrolls data, released in February, were around three times higher than consensus estimates and sparked a widespread worry that inflation is not under control. This caused a meaningful reversal of confidence, and then the bank failures that appeared in March moved the spotlight to further rate tightening combined with banking-sector fragility and contagion fears. February’s total returns for the index were still positive at 1.2% due to the rally early in the month, but fell in the second half and in March the index recorded a negative total return of -0.1% (-0.7% in price terms).9 The first quarter finished with a lack of conviction on loan assets, although for the period as a whole the index’s price and total return were 2.1% and 3.8% respectively.10

€8.6 billion of loans priced in the quarter (around half occurred in January), 55% lower year on year; 40% were re-financings.11 However, CLO primary issuance was overall more active than new loan primary: €6.7 billion of CLOs printed in the first quarter, down only 29% year on year.12 Warehouses and new CLO formation year to date have propped up, to some degree, asset prices. Liabilities widened after the banking crisis, though, and there haven’t been enough data points since then to say that they have recovered along with loan asset prices.

Amid the index numbers, we see a continuing bifurcation of the market. Performing names have continued to perform, with the macro influences of cost inflation, higher interest costs and slowing demand not derailing their credit story. Stressed and distressed names, on the other hand, have continued to struggle with little improvement in operations and little ability to refinance. Investors are busy trying to ensure they are holding those which will continue to perform versus those which may fall into stress or distress. There is only a minority of the investor base willing to lean into deteriorating credits, thus there is a chase for the better or best credits and a hollowing bid for those on the wrong side of the equilibrium.

Looking forward, it does appear that inflation is trending down – although we think it will take years, not quarters, to stabilise around central banks’ targets. The risk of recession-like or anaemic growth conditions, perhaps not deep but long, is in our view high. The focus should migrate further to credit quality and compensation for credit risk; as cost and interest inflation are likely to continue over the medium term, borrowers should be scrutinised for their degree of pricing power and value for service. On CLO formation, the market slowed in March but remains open and we think good credit selection will be increasingly important for CLO investors.

Credit Risk Sharing (CRS): The turmoil in the banking sector has been incredible but we continue to view CRS as a credible solution for meeting banks’ and investors’ needs. Recent events have only reinforced our conviction. Disruptive as this crisis has been in many ways, we consider the resulting dynamics highly supportive of the demand for and structure of CRS transactions and we expect to see extremely strong underwriting conditions for the rest of 2023. Sellers (banks) can substantially improve allocated capital efficiency and increase asset velocity while retaining important client relationships and their attendant fee income streams. Buyers (investors), meanwhile, can receive low-beta, high-quality, and predictable cash flows tied to contractual obligations not otherwise available or replicable in the capital markets.


1. Source: Minutes of the Federal Open Market Committee, 21-22 March 2023.
2. Source: Bloomberg; as of 31 March 2023.
3. Source: Bloomberg; as of 31 March 2023.
4. Source: Man GLG; as of 31 March 2023.
5. Source: Bloomberg; as of 31 March 2023.
6. Source: CoreLogic House Price Index; as of 31 March 2023.
7. Source: Bloomberg; as of 31 March 2023.
8. Source: Bloomberg and Credit Suisse; as of 31 March 2023.
9. Source: Bloomberg and Credit Suisse; as of 31 March 2023.
10. Source: Bloomberg and Credit Suisse; as of 31 March 2023.
11. Source: Bloomberg and Credit Suisse; as of 31 March 2023.
12. Source: Bloomberg; as of 31 March 2023.

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