Rates Volatility, Idiosyncratic Risks, Geopolitical Events, but Credit still Nosing Up

We arrived almost at the end of April and the European credit market remains strong even if the overall picture in Europe remains broadly unchanged and the recovery story of domestic consumption expected in H2 2024 is called into question by some strategists and economists. The risks to economic growth remain tilted to the downside (ECB conference) after a weak Q1. Services activity remained resilient while manufacturing firms are still struggling with a general weak demand. If the inflation will continue its decline and normalization, the ECB will cut interest rates in June as it was telegraphed in the monetary policy statement of Central Bank on 11th April. It is crucial to notice how recession concerns have been lifted for now by the majority of market participants.

The current background of geopolitical tensions and conflicts complicates the analysis of the possible scenarios in the US and in Europe for the remaining part of the year.

For understanding this 2024 for European investors we shall need to take a step back and observe where are we coming from. I define the past year the one of?corporate credit resilience. Against an overhang of weak sentiment for much of the twelve months (November and December the exception in the big picture) and despite financial surprises (Credit Suisse), sluggish earnings, rising perspectives of defaults, and sharply higher official rates and yield curves, total and excess returns in the credit market were strong, with leverage products (HY fixed and frn format, lev. loans, At1s, Hybrids) outperforming most other fixed income assets. The IG market remained behind. Structured products achieved stellar results.

The rally continued in the first months of 2024 but some vulnerabilities started to appear in the system that investors ought to pay attention to, at the moments of allocating the inflows and of shaping the portfolio’s profile.

Let’s see in quick points:

1) Rates are up again with the 10Y US Treasury at 4,60% and the 10Y Bund at 2,50%. The sell off in government bonds, which remain highly correlated, has been particularly gruelling. We are still well off the peaks registered in October 2023 when we touched respectively 5% and 3% in the two markets. The recent movement has been a surprise and was not contemplated by the majority of investors at the beginning of the year. Data played their role and FED comments completed the scenario (the communication has not been great). The European market followed the trends which took shape and played out in other parts of the world. I always had the idea that what usually happens between the last hike and the first cut points to carefully timing the investment strategies for govies and, as a consequence, for the most risk assets. This time is not an exception but simply a confirmation of what I observed in previous moments of easing in monetary policies. I don’t know how many rate cuts will be delivered but the direction of travel appears clear; I am still convinced that long rates (10+) will deliver more surprises than what is estimated and hoped by the investors. The path forward is rarely a straight line: for this reason I favour the middle of the yield curve, 2-7 years.

2) The credit market performed well in Q1 with significant yield tightening in all the credit cohorts. The set-up for European investment grade credit remains supportive (with few exceptions in my point of view), given the solid fundamentals, the improving technicals and above-average valuations when compared to the past. In October 2023 IG YTM in industrials at 4,5% and at 4,90% for financials were too enticing for being missed (the highest levels in a decade and with a choice across many names). Investors jumped in and drove down the IG YTM to 3,65% and 3,85% for banks at the beginning of April (excess returns YTD between 175 bps and 200 bps). I think the IG credits, at existing levels, stand to benefit the most from a scenario of flattish growth and future interest rates cuts. There is of course dispersion, and some sectors appear mispriced and rich.

On the other hand, the analysis for leverage credit looks far more intricate and nuanced despite the funding economics improved notably. We are observing “idiosyncratic surprises” (I explained my view in previous notes about it, arguing against this definition of surprise. I warned about Altice 12 months ago) and credit investors switched (finally) their focus away from rates and inflation into balance sheet affordability, Ebitda growth, cash flow production, and liabilities profile. When the investors did not do the switching exercise, the troubled corporates, previously financed without a second thought, took the helm putting the creditors against the wall. A&E deals and discussions around those cases will be long and painful. Creditors will confront other creditors and some players will play in advance outside cumbersome “cooperation agreements”. Legal documents on previous financial debt issued in bullish moments, allow multiple scenarios.

The liquidity remains abundant (supported by the inflows) and the investors remain sitting on large amounts of cash that could be put to work at the right opportunities (ask direct lenders on this point). New corporate issuance (large variety of names) has been well absorbed, BWICs in the?leverage loan market provided the paper the CLO platforms needed for the vehicles. Technical supply and demand dynamics remain the most important determinant of market movements and credit spreads direction. Inflows and a certain trading attitude against the benchmark, supported so far the credit spreads and the prices of specific credit names that should trade, probably, 10 figures below the actual levels.

Due to my view of moderate market widening from here, I believe how spreads decompression will allow better entry points and convexity trades than exiting opportunities. My idea is that HY credit, within contained equity drop-off, should not show extreme sensitivity to the timing and/or the magnitude of future interest rates cuts. The attention should be more towards each name's outright spread, spread relative to the broad index and peers in the same sector, and current spread per leverage versus the financial history. There will be more idiosyncratic risk coming out from European names that continue to screen mispriced against weak fundamentals and metrics. The problems are not coming from the lower quality borrowers that are regaining market access, but from existing HY names, once considered safe, where investors remain hesitant on the necessity of facing a debt stack restructuring. This?is?no?laughing?matter?and?anyone?who?thinks?it?is?deserves?to?wear?a?permanent?dunce?cap.

3) CLO market. The impact on the European CLO market from Altice and other distressed companies continues to attract a lot of questions but in general there is a broader apathy starting to emerge around the name and about the percentage of CCC bucket in the vehicles. This is maybe due to a mental attitude of PMs dealing with a “digested problem” in the portfolios that will require time and patience. There was also excessive excitement about a matter that it is smaller than what some comments wanted to highlight and to put in evidence. I explained and I wrote already in a previous note, how the risk remains manageable and how CLOs can live with this issue; the CLOs out of the reinvestment period will have to deal with it and other CCCs names more carefully than the vehicles recently printed, and decide if a refi makes more sense than a reset or the other way around, depending on the quality deterioration and tiering of the underlying HY pool. The price action around the downgrades and A&Es (liability management transactions)will be decisive. CLO managers will be closely scrutinized by the investors about their holdings and their investment attitudes (but memory here is short……).

Some weakness has been spotted in the last days in the sub-IG part of the capital stack but I consider the widening more linked to an excuse to take profit when the stock market was correcting than any specific issue emerging in some tranches or manager profiles. The primary in Europe is continuing to print CLO vehicles in a range of 10 bps difference in the total cost of capital stack: 230 to 240 bps above Euribor. All the primary sits curiously there. I expect the liabilities remaining at existing levels until the European Central Bank interest rate cut. At that point the AAA could trade 20-25 bps cheaper and AAs around 180-185 over Euribor. Total WACC will finish 25-30 basis points inside current pricing if we leave the remaining liabilities unchanged. For the lower part of the capital stack, we know already how the structures are resilient to shocks and defaults; tranches downgrades are unlikely at this stage. A widening of the credit market or an increase in the tail risk are the only headwinds for the more subordinated notes and we have already seen in 2021 (without going very far in time) how DMs of 640 and 925 bps over Euribor on BBs and Bs can coexist with AAAs inside 100. One thing is sure: securitized credit world offers liquid, defensive opportunities, and multiple securities for high-quality carry, a good feature and cushion for long term investors and hedge funds in a year that could see some volatility spike in Q3,Q4.

Prudent tranche selection and risk management within the different vintages and managers (seasoned or not ), with timely portfolio adjustments, will weather any negative surprise coming from geopolitical problems, rates, technicals or, in the best of hypothesis, the simple imbalance between demand and offer.

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