Value persists in IG, but higher interest rates are a threat. Opening the synthetic toolbox can help

Duncan Sankey

Portfolio director and head of credit research Cheyne Capital

Fiscal and monetary policy are pulling in opposite directions, but value in IG can be accessed via CDS and CSOs

Higher refinancing costs will likely herald decompression in high yield spreads (especially in US sub-single B credit, which seems to be defying gravity) and an increase in default rates, but the European energy crisis and attendant recession risks present opportunities in investment grade.

European IG credit spreads in the 90th percentile over five and 10-year ranges are compensating for cumulative default rates over the next five years in excess of 10% — beyond anything ever experienced, even during the Great Depression.

IG spreads have only been materially wider on a sustained basis during periods of systemic distress in the financial system (such as the 2008 global financial crisis, the Eurozone crisis and the pandemic), which, thanks to reforms undertaken in response to past crises, does not appear imminent. In addition, IG companies are well placed to cope with a weaker economic outlook. Many IG corporates have not only used the easy-money years to extend maturity runways, thereby mitigating refinancing risk, but they also enjoy historically high levels of profitability, which will enable them to absorb some margin erosion.

There has also been a creditor-friendly shift in attitudes on the fiscal front. The willingness of governments to support large companies waylaid by energy price volatility makes it unlikely investors will be sucker-punched by the rapid default of a hitherto safe IG name.

Indeed, an incipient return to dirigisme in European energy policy is heralding a reassertion of state control over energy companies. This may culminate in social ownership, which is generally favourable for creditors. Also, fiscal initiatives to soften the impact of energy price increases on consumers should take the worst of the recessionary sting out of the energy price tail.

Fiscal intervention does not come cheap

European governments are estimated to have pledged over €600 billion to date in support to corporates and consumers. While some will be recouped from windfall taxes, the bulk will need to be financed, and will weigh on balance sheets already engorged with pandemic-related debt.

In contrast to the pandemic era, fiscal and monetary authorities are no longer singing from the same hymnal. The latter are still operating expansionary real interest rate policies, and their price stability mandates will require rapid policy rate increases to tame inflation. Moreover, having engaged in a decade of balance sheet expansion (quantitative easing) they are now seeking to run balance sheets down (quantitative tightening). Thus, governments, whose own creditworthiness has been stretched by events of the past three years, will need to finance another round of fiscal expansion in a considerably less favourable supply-demand environment. Corporates will likely be crowded out; interest rates will increase.

This creates a conundrum for IG credit investors: while value persists in IG spreads, higher interest rates threaten value destruction for IG bonds. This problem can be resolved by opening the synthetic toolbox.

Leverage margins without financing costs

Strategies based on credit default swaps enable investors to take spread risk without also assuming rate risk. The unfunded nature of CDS also means they can be leveraged (to deliver equity-like returns) relatively simply on margin, without explicit financing costs. CDS also typically enjoy better liquidity than bonds, especially in periods of distress, when the relative standardisation of CDS contracts to those of bonds makes them natural conduits of liquidity.

A bout of short-end protection-buying induced by recession fears has also left IG spread curves unusually flat, providing an additional return kicker at maturity points where investors have good visibility over the evolution of corporate creditworthiness. CSOs may also be worth a look. Senior tranches enjoy sufficient subordination to insulate them from any historical level of IG default.

In what is likely to be a testing environment for cash credit, synthetic strategies can provide a complement to bonds and loans for a range of investors, allowing them to benefit from fiscal intervention, even if monetary policy is pulling in a contrary direction.

Share this article:

${prev-page}

${next-page}

Browse more Creditflux newsletters

Global credit funds & CLO's

October 2022 | Issue 249

Published in London & New York.