Curmi & Partners

Credit Market Roundup and 2022 Forecasts

By Simon Gauci Borda

On a year-to-date basis, the yield differential between corporate bonds and government debt widened across the board as spreads of non-investment grade corporate bonds widened by a larger degree when compared to investment grade corporate bonds. In fact, Euro-denominated investment grade bonds and non-investment grade bonds widened by 56bps and 132bps respectively while USD denominated investment grade and non-investment grade bonds widened by 42bps and 96bps respectively.

The wider corporate bond spreads occurred despite the rise in sovereign bond yields. Bond yields rose as investors expect central banks to continue on their current trajectory of tightening monetary policy by tapering bond purchases and hiking rates in order to tame the high levels of inflation which have recently been reported. In fact, on a year-to-date basis the yield on the German Bund rose by 117bps to its current yield of 0.99% while the yield on the U.S. Treasury rose by 151bps to its current yield of  3.00%.

The rise in sovereign bond yields and corporate bond spreads have been influenced primarily by expectations surrounding monetary policy but also due to other factors such as the ongoing conflict in Ukraine. Since Russia’s invasion of Ukraine in late February, corporate bond yields have risen due to the rise in inflation given the supply shortages and also disruptions which have been brought about by the war.

However, corporate debt, particularly non-investment grade debt which tends to include businesses with weaker capital structures, have been more prone to the ongoing conflict and the repercussions that war brings as the rise in the cost of raw materials leads to a compression of a business’s profit margins together with a strain on cash flows. Moreover, the increased uncertainty also weighs on confidence and business conditions which affect business investment as well as trade. These factors, coupled with a tighter monetary policy and a slowdown in economic growth, which has been recently reported for the first quarter of the current year both in the U.S. and in Europe, resulted in a broad market sell-off, including corporate bonds, and the widening of corporate bond spreads.

The recent disruption of business conditions has also given rise to an increase in global corporate defaults after fourteen months of mostly positive rating actions. The recent increase in defaults comes after a two-year period in which corporate bond issuers took advantage of the relatively cheap financing to shore up their balance sheets while at the same time extending their debt maturities with many starting the year with stronger balance sheets and high levels of liquidity.

The conflict in Ukraine has been a significant factor to the recent rise in defaults with companies based in Europe bearing the brunt of it due to their proximity to the conflict. However, ratings for corporates not directly affected by the war or the sanctions imposed have remained robust as they have not been as susceptible to the rise in commodity prices and disruptions.

Going forward, for the remainder of the year, corporate bond spreads are forecasted to gradually widen from current levels.  According to Goldman Sachs, European investment grade and non-investment grade bond spreads are projected to widen to 178bps and 495bps respectively from their current levels of 151bps and 459bps with U.S. investment grade and non-investment grade corporate bond spreads expected to widen to 140bps and 427bps respectively from their current levels of 135bps and 379bps. The projected wider spreads are warranted given the current macro-economic backdrop which is expected to persist coupled with expectations of central banks maintaining their current hawkish stance through rate hikes and a reduction in bond purchases.

On the other hand, the extent of widening in spreads should be limited given the lighter issuance calendar and the low levels of defaults. Net issuance is expected to be significantly lower during 2022 for both American and European corporate bond markets given the high refinancing activity seen in 2021.  Default rates both in the U.S. and Europe are expected to remain benign and hover around 2% and 1% respectively compared to the non-recessionary historical averages of 2.2% and 3.1%.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.