In the current tightening environment with rising interest rates, corporate credit investing is facing both challenges and opportunities. The U.S. Federal Reserve has embarked on an aggressive interest rate hiking cycle to curb high inflation, leading to a significant repricing of risk across financial markets. Corporate bonds and loans have sold off sharply as investors demand higher spreads to compensate for rising rates and worsening economic conditions. However, this market turmoil also presents chances for nimble investors. As weaker companies come under strain, stronger firms can seize opportunities to expand market share. By taking a selective approach and focusing on high-quality issuers, corporate credit investors can weather the storm and find bargains amid the volatility.
High yield bonds plunge as investors flee riskier assets
The prospect of significantly higher funding costs has hit highly leveraged companies hard. Yields on U.S. junk bonds have soared from just 4.4% in early January to over 9% now. Banks are struggling to offload risky buyout debt, incurring painful losses like in the Citrix deal. Moreover, market liquidity is evaporating as investors ditch corporate credit for safe haven assets. However, the carnage has been uneven. Lower quality issuers with floating rate leverage have suffered the most damage. Many zombie firms hanging on by cheap debt may finally go under. But higher rated companies have maintained much better access to financing.
Default risks remain contained for investment grade firms
Despite the market turmoil, fundamentals for stronger investment grade firms continue to look resilient. Earnings and cash flows remain healthy enough to cover higher interest costs. Maturities are well staggered, with minimal near-term refinancing needs. Companies took advantage of ultra-low rates during the pandemic to push out maturities and fortify their balance sheets. Consequently, the spike in borrowing costs has yet to materially stress stronger credits. However, complacency would be unwise. A protracted economic slump and erosion in operating profits could change the picture.
Parts of the market offer compelling value for selective buyers
The repricing of risk has left many corporate credits trading at levels that now compensate investors for the fundamental risks. High yield spreads have widened dramatically, pricing in a severe recession that seems unlikely to materialize. Meanwhile, higher quality investment grade issuers are faring much better than feared. Selective buyers have an opportunity to upgrade credit quality and still generate attractive income. For example, a BBB-rated issuer may have double the spread of a single A credit, while showing much better business durability. By avoiding the weakest links and focusing only on issuers with sound finances, corporate credit investors can turn the challenges into profitable opportunities.
The current environment calls for disciplined corporate credit investing. A passive strategy could suffer badly amid thinning liquidity and declining prices. But savvy active managers can upgrade issuer quality and take advantage of market dislocations. By minimizing downside risks while diversifying away idiosyncratic blowups, investors can generate attractive income from corporate bonds and loans at a time of meager yields across markets.