The change in policy in 2022 has triggered a series of dominoes for asset markets. Government bonds were the first to fall in the first quarter, while other assets also followed aggressively in the second quarter. Quoted assets are instantly marked to market (which can often be unpleasant) while illiquid or private markets may retain prior asset valuation marks as there is no observable price where the discovery of price could occur. Is it worth considering what those realizable values might be if higher quality or liquid public assets are already at -10, -20, -30%?
Is a credit crisis about to burst?
The dominoes of change are quickly drawing attention to credit defaults, as it stands to reason that refinancing the stock of low-rated corporate debt will become increasingly problematic. The Australian government was borrowing money over 10 years at 1.05% in August last year, those rates have now risen to over 4.05% today. If the government has to pay more than 4% when it was paying a little above 1%, spare a thought for companies that could have borrowed at very low rates and are now being asked to refinance at a government yield of 4% plus some large credit spread component. How long will the markets trust these poorly rated companies to refinance at such punishing levels of interest rates? The danger here is that they cannot carry over these existing loans. This means that there is no more credit granted and that they must also REPAY the original amount of the loan. This is exactly how a credit crisis starts.
Markets are basically saying “we won’t lend you again and we’d like a refund as well.” This usually requires the lender of last resort – the central bank – to step in and provide a safety net. .
This is the political pivot that we have been writing about for some time and that marked a turning point in asset performance. But how does a central bank do that here with inflation generally between 5% and 8%? Central bankers are now rapidly raising rates as tackling inflation has taken top priority over rescuing zombie firms from bankruptcy, generating material strains in the credit complex as many investors flee the investment class. assets.
Credit risk has been spectacularly dormant as the widespread decline in long-term government bond yields since the 1980s, along with support from central banks, has fostered a ‘start-up’ environment for the asset class. , rebellious by the massive support of flows and the sponsorship of investors in the “search for yield”, under the financial repression of low interest rates. This patronage and flow appears to have ended with a mind blowing sell off in rates markets this year, leading most asset markets to poor performance. Many public credit assets also underperformed, primarily due to their inherent fixed income duration, rather than significant credit risk recalibration (spread).
The US Federal Reserve (the US Fed) is rapidly approaching levels that distorted credit markets in the last bullish cycle of 2018. At that time, in a peaceful and stable world, the US federal funds rate soared at 2.50% before the credit markets foreclosure. in November 2018, leading to significant tensions on the markets until December 2018 for risky assets.
The US Fed rose to 1.75% this week and suggested its next move would be a 0.50% or 0.75% hike to 2.25 or 2.50% in July to continue the fight against the inflation by killing demand in the economy.
The forces facing corporate credit markets today
So the next complex issue facing the markets will likely revolve around credit default and the stunning resurgence of credit risk in the corporate credit fixed income sector. Credit is a highly specialized market that is little understood by most investors. Credit quality, as measured by rating agencies, ranges from highly converted (but low-yielding) AAA-rated issuers to lower CCC-rated issuers classified as having substantial default risk (known in the markets as of “junk”). Due to the credit risk inherent in these lower-rated securities, yields are much higher to incentivize investors to assume the risk of default.
Spreads on CCC-rated US corporate bonds are approaching 1,000 basis points for the first time since the Covid-19 crisis, when the US Fed magically halted default issues by flooding the market with unprecedented amounts of cash and buying corporate credit in the context of Covid-19. 19 stabilization programs.
Such market support looks very hard to come by this time around as central bankers are rapidly raising rates to fight inflation.
Would you lend money to a buy-it-now platform or a growing business without sustainable profits to meet debt repayment in the current environment? Luckily for Australian investors, we have very few names like this, but our corporate credit shifts its sympathy with the global markets that are teeming with such names.
Rate hikes hit in an uncertain world
With substantially higher rates now priced by government bond markets, the economy is set to slow rapidly as rate hikes bite, hit the public, lower confidence and reduce discretionary spending. Liquidity and asset quality will become important considerations for portfolios seeking to benefit from deep discounts on many quality assets. We don’t expect rates to fall back to anything like the emergency levels we saw post-pandemic, so it looks like the revival of credit and default risk could be with us for some time to come. as we transition to a structurally higher rate environment than in recent years. It is important to recognize that the scenario of the latest episodes of a corporate credit crisis (Central Bank rate cuts and quantitative easing) will not work in a higher and unstable geopolitical environment. This policy pivot is simply not available if inflation remains above the Central Bank’s mandate levels, as one would expect for the remainder of 2022 due to the global energy shock.
Jamieson Coote Bonds (JCB) is an investment manager specializing in high quality domestic and global bonds, including a global absolute return strategy. Stay up to date with our latest information by following us on LinkedIn or visit our website for more information.