Higher interest rates are expected to erode the value of lower credit-rate bonds, while investment-grade credit could outperform, especially bonds issued by banks, according to Robeco’s latest Credit Quarterly Outlook for Q4 2023.
While many investors believe a soft economic landing is more likely than a recession in the US, global asset manager Robeco believes caution is still warranted.
Robeco director client portfolio manager APAC, David Hawa, prefers investment grade markets and maintains a quality bias within all credit strategies. Once central banks have finished raising interest rates and volatility in interest rate markets decreases, investment grade markets offer the best risk reward profile as the impact of higher interest rates feed through the US economy with some companies facing difficulties in making debt repayments as their cost of funding increases.
“We have witnessed the sharpest hiking cycle in the past 40 years as a measure to combat very high inflation. We are probably close to the end of this cycle, but it is likely we have not yet seen its full impact.
“There could be some collateral damage down the road, similar to what we witnessed in March this year during the US regional banking crisis.
“This is the reason to remain cautious on the riskiest part of credit markets, and as a result, we favour higher-quality corporate bonds. Investment-grade bonds could fare reasonably well in this environment if the recession isn’t too deep. We’re preferencing investment grade over high yield, and within high yield bonds, we strongly advocate for a quality tilt,” he said.
Within high yield strategies, Mr Hawa said investors can run a strong quality tilt in their portfolios by being overweight BB corporate bonds versus the lower rated categories, and to take credit exposure via the banking sector.
“In a decompression scenario, expect to see underperformance of weak single B rates bonds and corporate bonds rated CCC compared to bonds rated BB and higher,” he said.
According to Mr Hawa, interest coverage ratios could fall to stressed levels on a sizable portion of low single-B and CCC-rated corporate bonds once a significant part of their debt gets refinanced at current market yields. Within investment grade debt markets, he believes European bank debt offers the best value.
“Banks benefit from a higher rate environment via improved interest margins. Senior banking paper continues to trade wider than historical averages.
“More pain on the real economy is in the pipeline as the impact of higher interest rates feeds through the US and other economies,” he said.
According to the Q4 report, higher interest rates have taken longer than usual to feed through economies given imbalances created by the Covid pandemic. These included high household savings reserves, catch-up demand for goods and services, including strong demand for cars, and high levels of fiscal support, especially in the US, which has supported growth and employment. As these factors begin to fade away, the recent increase in interest rates will start to have its impact on those corporates with a high debt level and a need to refinance.
“The hiking cycle will most likely surface a few more problems that are difficult to predict. We have seen this unpredictability over the last few years with the Liability-Driven Investment crisis in 2022 and the regional banking problems in the US in March of this year.
“Aggressive hiking cycles tend to lead to policy errors by central banks and could cause collateral damage in sectors of the economy that are unable to sustain a rising rate environment. This time is no different,” said Mr Hawa.
