Weekly Investment Commentary: Giving high yield credit sectors their due
Bottom line up top
- Balancing today’s big risks — inflation, recession and earnings — is no small task. June’s 9.1% CPI print was the latest inflation data jolt investors have had to absorb this year. The unwelcome reading points to another 75 basis point rate hike at the July Fed meeting, with the market pricing in a sizeable chance of a full 100 bps move. That should please investors who prioritize inflation-fighting, but may unsettle the “growth is slowing too fast” contingent worrying that the Fed will push the economy into recession—and recession risks have clearly increased since the start of the year. Meanwhile, as inflation continues to squeeze corporate profits, negative earnings revisions may pose the biggest risk to equities in the second half of 2022.
- We have a relative preference for high yield credit sectors. Nuveen’s Global Investment Committee believes credit assets, specifically high yield bonds and senior loans, currently offer a more favorable risk/reward tradeoff than equities:
- Their yields look attractive.
- Credit fundamentals appear strong. We don’t expect defaults to rise materially, even in a recession, as debt burdens aren’t excessive and low financing rates have been locked in.
- Given today’s starting point, high yield bonds and loans likely have less downside potential than equities while offering high current income.
Portfolio construction considerations
Credit fundamentals support the case for high yield and loans. In the case of high yield, interest coverage is at its highest level since 2008 (Figure 1). This means borrowers are generating operating profits that cover roughly four times their annual interest expense, making them well positioned for a potential recession.
Additionally, issuers have locked in low interest costs for several years: Figure 2 shows the percentage of current debt outstanding that matures each year in the high yield and loan markets, with 75% of that debt maturing after 2025. This not only mutes the impact of any increase in interest expense, but also helps companies avoid large principal payments. Lastly, we think today’s historically low default rates are unlikely to rise above current market expectations of about 5%.
“We see more near-term risks for equity markets than we do for fixed income credit sectors.”
We recognize that credit sectors aren’t immune to spread widening as growth slows. And over the long term, we expect equities to provide higher upside. But stocks appear more vulnerable to near-term risks, particularly amid the uncertainty of the current earnings season.
We recently “stress tested” these asset classes and found that both high yield bonds and senior loans have less downside price sensitivity than equities, with coupon income providing a much greater cushion than equity dividend yields (Figure 3). On balance, investors seeking to position portfolios in the current fraught environment may find that a relative focus on credit over equities offers a compelling risk/reward opportunity.
“Attractive yields, solid fundamentals and prospects for downside protection make high yield and loans look especially compelling today.”
Nuveen’s Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.
Regular meetings of the GIC lead to published outlooks that offer:
- macro and asset class views that gain consensus among our investors
- insights from thematic “deep dive” discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
- guidance on how to turn our insights into action via regular commentary and communications
Endnotes
Sources
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