Credit Investors Should Proceed Cautiously

Credit assets have sold off in recent weeks in unison with other risk assets, as market concern has shifted from one extreme of growth and inflation running too hot to another of stagflation, or even outright recession. Despite the improvement in credit pricing, we believe investors should be patient when adding to high-beta credit portfolios.

The recent widening in credit spreads is unusual. The 120-basis point (bp) move in high-yield (HY) spreads over the last three months is a roughly 1 standard deviation move, but not extreme—HY spreads moved 543 bps in first quarter 2020 and 640 bps in fourth quarter 2008. HY spreads now look more attractive, but not excessively so, as valuations were previously stretched. The -10.7% year-to-date return for the Bloomberg High Yield Index leaves its option-adjusted spread at roughly the 50th percentile. Meanwhile, floating-rate assets have held up much better, with the S&P/LSTA Leveraged Loan Index, for example, only down 3.1% year-to-date through May 24.

Credit markets could remain volatile for some time, given the potential for weak economic data and uncertainty around expectations for tighter monetary policy. Should economic activity deteriorate, healthy fundamentals should provide some support. As of first quarter 2022, interest coverage ratios for US HY borrowers are around 5.5 times according to Bank of America, leaving a comfortable cushion even if borrowers need to refinance at rates 200 bps–300 bps higher than seen in 2021. Relatedly, HY default levels are well below historical averages (sub-1% at the end of March), and elevated interest coverage means most analysts do not expect default levels to rise materially over the next 12 to 18 months.

For those looking to immediately deploy capital, structured credit—such as collateralized loan obligation (CLO) debt—offers a compelling combination of elevated spreads and solid fundamentals. For investors concerned over the credit cycle, rising home values and thus, homeowner equity, mean US residential-backed mortgage securities might be attractive. Weighing current conditions, we also favor opportunistic mandates that can play in both public and private debt markets, and note that the private lending markets to which many borrowers have turned currently offer attractive spreads.