Certain Companies And Industries Could Start To Feel Their Pricing Power Fade As Consumers Struggle With The Squeeze On Real Incomes

And what does this look like for corporate IG?

Josh: The 10-year US Treasury yield spent most of the last decade between 0.50% and 2.50% and IG credit spreads traded in a tight range as well.7 Because of this incredibly low-yield environment, fixed income investors were pushed to look for additional yield in lower-quality asset classes to secure the income they required. Moreover, higher-quality, longer-duration assets had significant total return risk due to the potential for an eventual rise in interest rates. This is exactly what we have seen year-to-date in 2022.

Though there was certainly some weakness in widening credit spreads, rising US Treasury yields drove most total return losses in fixed income year-to-date. We believe that this outcome created a path for longer-term tailwinds for IG credit going forward.

First and foremost, even if there is a recession, the probability of default for IG issuers is very low. Balance sheets remain generally robust, providing most IG corporates with more financial flexibility to navigate a period of slowing economic growth. This is not to say that spreads won’t widen; they can widen significantly if we enter a recession. But we have reached a point in time where investors can play both offense and defense through their allocations to US IG corporate bonds. The defensive benefits of higher US Treasury yieldscan materially offset credit spread weakness going forward.

Fixed income is finally delivering income! Overall, we believe that with higher yields in the asset class, the risk-reward balance of current valuations has improved materially compared to the start of the year. In our opinion, this makes IG corporates a more attractive place for investors seeking relatively safe income. However, due to ongoing market uncertainty, slowing growth and deteriorating fundamentals, we acknowledge spreads can go wider and are certainly up in quality today within our US IG allocations to preserve liquidity and take advantage of any potential volatility in markets.

If the Fed keeps interest rates higher for longer next year, what near-term opportunities do you see across IG sectors?

Josh: Given an uncertain environment based upon our view of the Fed’s future interest-rate hikes, which is higher than widely anticipated, it likely means volatility will remain elevated for the foreseeable future. Additionally, our belief is Fed Chair Jerome Powell appears more concerned with continued tightening and as such, we do believe a shallow recession is likely over the medium term. However, this doesn’t appear to be priced into earnings estimates. In times of increased volatility, higher-quality credits with strong fundamentals and less sensitive end-demand are likely to outperform. We are therefore pushing more of our portfolio risk into non-cyclical sectors and still believe the US financial sector has strong risk-adjusted return potential, given elevated spreads and very strong capital levels.

And from an HY sector perspective?

Glenn: Higher rates and inflationary pressures will not impact all companies equally, and while many companies are able to increase prices to offset cost increases, others are suffering pressure on their margins. Monetary policy is driving up the cost of borrowing, which will have a more severe impact on companies with unhedged exposure to floating-rate debt. Given the numerous challenges facing HY issuers, we expect to see increased dispersion of returns among indi- vidual HY bonds in the coming years. In our opinion, this environment highlights the importance of active management in the HY asset class, as individual credit selection will be key to driving future performance.

We are currently seeing opportunities in select issuers in cyclical industries, like chemicals, where the market is focused on the potential for an economic slowdown to hurt top-line growth. However, we are focused on each company’s cash-generation profile and the ability of its capital structure to withstand economic headwinds. We also like classic defensive industries, like packaging and utilities, where demand is not tied to the level of economic growth and their bonds provide an attractive risk/reward profile. And we continue to like the energy sector, where we see ongoing fundamental tailwinds and the potential for elevated levels of ratings upgrades.

Which HY sectors give you the most cause for concern looking into 2023?

Glenn: As we enter 2023, we believe that certain companies and industries could start to feel their pricing power fade as consumers struggle with the squeeze on real incomes. At the same time, inflation seems to be stickier than expected and will continue to push up costs, as well as keep the Fed committed to its monetary policy tightening path.

In such a scenario, there are several areas that are cause for concern. Companies with more elastic end-consumer demand and/or exposure to the lower-end consumer are likely to face ongoing pressure. This category includes many retailers and consumer products companies. Separately, companies with limited free cash flow—often due to high debt loads—or reliance on future cost savings to make their capital structures work, will be challenged as financial condi- tions tighten. Many leveraged buyouts (LBOs) of the pastseveral years fit this profile, and we are highly selective when evaluating such deals. We are also wary of industries facing secular decline, such as wireline telecom, or those under- going rapid changes to their competitive landscape, such as autos—given the rise of electric vehicles (EVs) and their uncertain impact on the industry—or the broadcasting/pay television ecosystem. While some of these changes will take years or decades to play out, we prefer to be positioned now ahead of any potential acceleration in the pace of change.

And from an IG standpoint?

Josh: Looking ahead, companies are going to face some challenges. Margins are likely to continue to feel the squeeze from elevated labor, financing and input costs. Corporates are already feeling the effects of significant wage increases, as evidenced by the first layoff announcements from various technology companies. While companies are still benefiting from interest costs that hovered near generational lows for more than a decade and frontloaded borrowing, rising rates will certainly bite into the broader economy, affecting both consumers and future corporate borrowing needs.

Also, though we have seen improvements in supply chain issues, inflation will most likely stay higher, even if it stabilizes or retreats, and for longer than consumers or markets are accustomed to. This will continue to impact global growth.

Considering our expectations for a potentially challenging market environment over the near to medium term, we believe that cyclical consumer-focused industries and companies with high levels of exposure and sales to weaker markets, such as Europe, will likely underperform. We are also less excited about commodity sectors. We believe that although fundamentals are decent and commodity prices may hold up, valuations are stretched. Weaker economic growth is likely to cause spread volatility in these sectors as aggregate demand slows.