Christian, markets first! Investors have been jittery since the start of 2022, with many experts predicting an economic recession, some even warning of a “Minsky moment.” Yet, risk assets have shown surprising resilience, climbing a wall of worry. What’s your assessment? Where are we in the credit cycle?
First, let’s define what a “credit cycle” stands for. Credit cycles start with periods characterized by easy money to borrow. Usually, this expansionary phase is supported by lower interest rates and less stringent lending requirements facilitating both taxpayers and institutions to have access to a larger amount of credit. Overall, all these stimuli translate into an increase in economic and business activities. The latest extraordinary monetary and fiscal easing boosted economic activity and inflated financial assets. Central banks have created an artificial environment as a consequence of their extremely supportive measures based on negative interest rates, where the latter are illogical, both financially and mathematically speaking. Expansionary credit phases are followed by a general contraction in the accessibility of credit. These periods are normally characterized by higher interest rates, an inflationary pattern, and a contraction of loans. Companies’ credit spreads widen and the number of defaults increases. In fact, increased leverage is no longer supported by healthier earning growth. Contraction periods continue until a big dislocation occurs and the underlying risks are reduced for the lending institutions. This is usually the turning point where the cycle reaches its lows, after which a new benign phase begins.
Figure 1: Credit cycle
Rates next! Major central banks, save for Japan, appear to have finished raising rates. Can we expect a swift pivot, or will “higher for longer” be the mantra?
Both the speed and the entity of hikes occurred so far are currently detrimental to the accessibility of credit. As a matter of fact, the cost of debt is definitely higher than a couple of years ago. This situation could last for a longer period compared to the past, since Central Banks may have stopped increasing the interest rates, but they simultaneously warned that they will hold current monetary conditions for now. Policymakers have raised rates by approximately 400 basis points on average in advanced economies since late 2021, and approximately 650 basis points in emerging market economies. The US economy is still running well, even though most of the macro indicators are laggards. In Europe, the current economic situation is already showing evidence of the tightening of monetary policy. The main objective is to cool down the inflationary pressure, hoping for a soft landing.
M2. Source, FRED, St. Louis FED
Back to credit! Do you see dislocations or relative value opportunities across the rating spectrum?
Current default rates in corporate credit markets are subdued despite significant financial conditions’ tightening. This is the main reason why the high-yield spectrum performed very well compared to the other buckets of credit. The ability and the right timing for many issuers to take advantage of the low-rate environment in the past allowed them to extend their debts at very attractive rates. Should we expect a soft landing, not only for the next pre-announced economic contraction but also for credit affordability? What about the default rates when we approach the next maturities? I would like to focus on the European market, as this seems to be more fragile. A good test for the high-yield market is the upcoming year. According to the latest data available, there are almost €80bn of bonds maturing in 2025, which is close to 19% of the European high yield index, in need of refinance. Those companies can be expected to manage new issues during the next 18 months to avoid any pressure on ratings. Acting like that, they will prevent leaving their debt outstanding until the last minute. A rational investor should avoid any extra risk when buying high yield bonds by considering the opportunity to park the liquidity in investment-grade bonds. In particular, the European iTraxx Crossover runs with a spread of close to 430 basis points, only 100 basis points wider than the 5-year average. If the Crossover would reach almost 700 basis points, as during the period dominated by Covid-19 and during the 2022 widening in credit spreads, the risk of vanishing carry trade is real and not negligible.
European iTraxx Crossover, Source: Bloomberg
Christian, you’re a veteran of the market with nearly two decades of experience! What’s your new role at Ayaltis, and what are you most excited about?
I joined Ayaltis, a financial boutique, only a few months ago, allowing me to return to the asset management industry after having spent several years in the banking sector. At that time, working closely with end investors offered me a realistic perception of their needs and desires. Investors usually require stable returns, and they are generally concerned about volatility, or, to rephrase, they are not willing to accept a high dispersion on their incomes. Either way, in recent times, fixed-income basket volatility has been higher than the volatility registered on the equity side. Working for an active manager allows me to capitalize on market trends and inefficiencies. Regarding the fixed income space, the ability to seek and access better risk-adjusted return opportunities represents the added value offered to our end investors. I always adopt an investment strategy focusing on a strong relative value approach. This strategy targets the identification of an additional premium when investing in bonds. Looking for the extrapolation of alpha from some niche of fixed-income securities allows investors to profit from a consistent benefit compared to traditional vehicles. The extra premium can be considered insurance for periods of high volatility. It naturally offsets the impact of return dispersion by offering investors an alternative to investing in fixed income instruments.
ICE BofA Move Index, a measure of U.S. bond market volatility that tracks a basket of OTC options on U.S. interest rate swaps. Specifically, it tracks implied normal yield volatility of a yield curve-weighted basket of at-the-money one-month options on the 2-year, 5-year, 10-year, and 30-year constant maturity interest rate swaps. Source: Bloomberg
Execution is key when it comes to money management! Why did you choose an Active Managed Certificate (AMC) as a vehicle for your investments?
In comparison with other financial vehicles, AMCs have multiple advantages. First of all, in terms of final costs, AMCs are built to preserve investors’ performances with lower management costs, whilst allowing increased flexibility. There is no additional credit risk as the assets are fully segregated. Furthermore, by choosing the right structure, investors could benefit from fiscal optimization, expanding their returns as a result of the gross compounding effect. In a world characterized by higher coupons, the final impact is not negligible at all.
All views expressed on this site are my own and do not represent the opinions of any entity with which I have been, am now, or will be affiliated. I assume no responsibility for any errors or omissions in the content of this site and there is no guarantee for completeness or accuracy. The content is food for thought and it is not meant to be a solicitation to trade or invest. Readers should perform their investment analysis and research and/or seek the advice of a licensed professional with direct knowledge of the reader’s specific risk profile characteristics.