By Simon Gauci Borda
In recent weeks the ‘flight to safety’ approach has ensued within financial markets as investors increased their exposure to safe haven assets given the current economic and geo-political backdrop.
The bearishness exhibited by the market could be justified by the hawkish monetary policy, rampant inflation and geopolitical crisis. As a result, corporate credit spreads have widened with the rise in sovereign bond yields. Moreover, corporate credit spreads have remained elevated during the recent pullback in sovereign bond yields.
At the time of writing, the yield on the Bund stood at 1.13%, a level last seen in 2014 and significantly above the level seen towards the end of 2020 when the Bund was trading in negative territory. Despite the higher Bund yield, European corporate bond spreads have widened markedly. European Investment Grade bond spreads have increased by circa 110bps since the start of the year to circa 204bps while wider spreads have been more notable in the European High Yield segment of the credit market as spreads have increased by circa 326bps to 645bps since the start of the year.
The three major themes influencing credit markets are all interconnected. The rise in inflation has been exacerbated by the ongoing conflict in Ukraine while the decision taken by central banks to hike rates has been driven by the high levels of inflation to which they are mandated to keep close to or below their 2% target.
Inflation results in higher operating cost structures for companies with management teams having to decide whether they should absorb the cost or pass on the increase to consumers with the former decision leading to lower profitability and cash flows. The rise in central bank rates in response to the high levels of inflation will also eventually lead to higher financing costs which may further dampen corporate profitability and cash flows. These reasons, coupled with the ongoing war in Ukraine, have investors believing that businesses may face significant headwinds in the coming months due to a decline in business profitability affecting the ability of corporate bond issuers to finance their debt obligations.
However, despite the gloomy picture which is being painted by economists and market commentators alike, fixed income issuers have generally maintained robust credit metrics which have strengthened from the pandemic lows. In fact, European Investment Grade non-financial corporate bond issuers reported an average net leverage of 2.2x as at the end of the second quarter, a level last recorded during the summer before the pandemic, while European High Yield non-financial issuers averaged a net leverage of 3.9x during the same period which is marginally higher when compared to the level recorded before the pandemic.
It must be noted that current metrics are also influenced by the significant debt refinancing that occurred during the pandemic as issuers refinanced existing debt through lower coupon payments and longer dated debt as they shored up their balance sheets with significant amounts of liquidity due to the high level of uncertainty at the time.
In conclusion, financial markets have entered a period whereby the focus has shifted away from the pandemic and onto the implications of the conflict in Ukraine, the effects of high levels of inflation and tighter monetary policy. As a consequence, corporate bond markets have sold off substantially in recent weeks and months with spreads widening considerably. While on a fundamental basis corporate bond issuers seem to be better positioned when compared to the period defined by the pandemic, investors should expect to see a weakening in credit profiles over the coming months due to expectations of weaker profitability. While spreads are expected to remain at current levels through the end of the year, according to the latest set of projections released by Goldman Sachs, investment grade issuers may be downgraded lower within the investment grade rating scale and possibly downgraded to high yield. Moreover, the number of defaults within the high yield market is expected to climb given expectations of slower economic growth and the possibility of a recession occurring within the next year.
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.