Watching Developments

Buckle up. I think those two words perfectly capture the current environment in the credit world. Both Europe and the US are sending investors clear signals to wake up to the need for more active and thoughtful money allocation across different asset classes.

For over three years, the fixed-income bond market has been primarily driven by inflation data and the responses of central banks, which have continuously grappled with the actual and expected inflation trajectory. In 2022, the global credit market suffered, but by 2023 and into 2024, it rebounded, fueled by more optimistic inflation outlooks, robust technicals, stronger-than-expected corporate earnings, and a massive influx of capital leaving money market funds and government bonds. The excess returns in investment-grade (IG) and high-yield (HY) bonds over the last two years are a testament to the numerous factors that have worked in tandem to tighten credit spreads in the corporate world. Notably, CCC-rated credits have vastly outperformed, and distress ratios (credits with OAS greater than or equal to 10%) have been steadily declining from the cycle-highs of spring 2022.

However, that was the past.

Looking ahead, the future is more complicated than the often-heard expression, "heading into a Goldilocks scenario." In my view, investors should need to act with more caution and adopt flexible strategies. It's time to move away from asset classes where valuations are no longer competitive or mispriced (e.g., AT1s for more than 70% of the total market, or certain hybrids) compared to historical standards, and where the risk premium has become excessively tight. Instead, the focus should shift to relative value trades, which offer a better cushion if the market shifts toward decompression. While they may be few, pockets of value still exist within the credit world.

As we entered 2025, new investment scenarios are emerging, and it’s important to consider the key concerns for the coming months. In my opinion, these should include (aside from geopolitical matters):

1. The potential resurgence of inflation. We’ve seen this happen before, most notably in the late '70s in the U.S.
2. Central bank responses to trade wars. How will central banks react as global economies engage in trade conflicts? Are the current interest rates truly restrictive?
3. Rising debt and persistent deficits at the governments level. This is an issue for both the U.S. and Europe. Steeper yield curves present a new scenario that many investors may not be prepared for. Should we remain aggressive or cautious on duration from a risk adjusted return standpoint?
4. The lack of focus on productivity and sustainable economic growth. Politicians are prioritizing trade wars and tariff policies, often neglecting the need for solid initiatives to boost productivity. A drop off in economic growth and perspectives would compound key issues in many corners of the credit world.
5. Growth concerns continuing to drive asset spreads and market reactions. We've seen this in the stock market since Trump's election. Even though the exact transmission channels in specific sectors are hard to pinpoint, tariffs will undoubtedly impact economic activity.
6. Leverage problem or unsustainable balance sheets in the credit world. Some companies, even those that have undergone amendments and extensions, may not be able to maintain their current structures. This is especially true if interest rates remain elevated, as they’re unlikely to return to the zero-rate environment of the past decade.
7. The impact of CLOs (Collateralized Loan Obligations). Both older CLO vintages and new issuances in the U.S. and Europe are disrupting the normal functioning of the credit market. Repricings are accepted without possibility to challenge the economic conditions. The CLOs rely on paper and high-beta names to maintain the arbitrage yet finding viable alternatives to purchase in place of disposed underperforming credits has become increasingly challenging. Bonds and loans trading at a discount in the secondary market are being pursued for their ability to lower the average acquisition price of CLO portfolios. The credit quality is a secondary factor in asset selection. While CLOs are structured to handle volatility, some of their underlying assets exhibit low-quality earnings and face poor survival prospects in a slowing growth environment with diminishing risk sentiment. Many of the credit issues in stressed names have been flagged for years, and further restructurings are likely, leading to losses and prolonged negotiations on cooperation agreements that offer only temporary solutions, as demonstrated by recent amendments and extensions (A&Es). CLOs are likely to continue holding onto their paper regardless, but one must question: is CLO mezzanine paper too tight at current yields? And where is the equity return over the next 12-15 months? Are MM US CLOs offering the correct spreads over large corporates broadly syndicated CLOs?

At times, investors must chart their own path to find the optimal allocation that aligns with their target returns and risk tolerance. While the credit market may remain supportive and tight for an extended period, it’s crucial not to overlook the warning signs. Even in a low-default credit cycle, savvy investors should focus on risk mitigation—buying inexpensive hedges, avoiding credits with inflated valuations and negative convexity, and shorting weak names that lack sustainable turnarounds, are on shaky ground, and have limited visibility. As we head into end of Q1 2025, the risk balance in the first two months seems skewed to the downside. Are we finally acknowledging that the noise is growing louder, and the once-guaranteed carry trade script is losing its importance?