Article
Against the backdrop of the inflation data and recent positive market moves, Credit Suisse Asset Management is maintaining a strongly bullish medium-term view on fixed income.
January 27, 2023
For Qualified Investors/Professional Clients Only
...the upside potential for simple investment-grade fixed income.
...the base case for investment-grade fixed income.
...the downside protection afforded by investment-grade fixed income.
Why is this uncomfortable for a Head of Fixed Income? Because in over two decades, we have rarely had a view that is so lacking in nuance and caveats and is so bullish. There undoubtedly are other asset classes and even parts of the broader fixed-income universe with greater upside potential. Other asset classes may also offer greater protection during a deep recession or an extended period of moderate inflation. As an overall package, however, and even after having delivered great returns since we last wrote, boring, standard vanilla investment-grade corporate bonds look great. The technicals are strong, the fundamentals are okay, and relative value has rarely been better than this.
Since we last wrote in December, we have seen inflation take a significant, concerted, and coordinated turn for the better. Much of this is related to those input factors that moved first in lifting inflation and that have quickly reversed, such as those related to energy and supply-chain disruptions. Labor markets around the world remain very strong, and we are seeing early signs that wage-price inflation may be a rather pernicious laggard tending to keep inflation high. Central bankers around the world have needed to be firm both in word and deed to try to prevent markets from assuming that pivots are bound to occur. Part of this, of course, is to prevent inflation from becoming self-fulfilling, but part is surely also because they acted too little and too late when inflation first emerged. Moves by the Bank of Japan stand out among recent central-bank actions. We are watching developments at the Bank of Japan closely because theirs is a very difficult future path to predict. Our end-2022 report card for central banks reads “satisfactory.” The first half of the year was rocky, but the second half saw improvements in both effort and achievement.
Credit cycle effects
Overleveraged underlying corporates
Consumer defaults
Less liquid areas of fixed-income markets
The following chart shows the development of US delinquency rates for auto and credit card loans over the past 20 years. The term delinquency refers to the state of being in arrears. When a borrower is delinquent, he or she is past due on their financial obligations such as a loan. Financial delinquency often leads to default if the arrears are not brought up to date. The delinquency rate typically goes up in times of weak or negative economic growth and rising unemployment, and vice versa. High delinquency rates are a problem for the profitability of a banking system, and individual banks typically respond to a worsening economic outlook by tightening their lending standards in order to keep potential loan losses contained.
US Commercial Banks
Auto Loan and Credit Credit Card Delinquencies, in %
Source: Credit Suisse Data as of 30.12.2022
The credit cycle
Credit cycles come in all shapes and sizes, sometimes fast and focused, and occasionally slow-moving and all-consuming. One thing that is consistent about them, though, is that they cannot be avoided. They are a symptom of the behavioral element of finance. We expect to start to see those effects in Q1 2023 and will watch closely as they evolve. Defaults (even a small number of them) and delinquencies tend to be the first signs that tightening will accelerate. We mentioned this in our last note.
For illustrative purposes only.
We are only just entering the tightening phase of the credit cycle, much can go wrong from here.
Being fixed-income investors ourselves, we often speak with members of our clients’ teams who focus on fixed income. The challenge they most often pose to our core view is that they hear that “all is well in high-yield” from other managers. We simply do not agree with that view. We see signs of looser covenants, potential for lower recoveries and, most importantly, leverage creeping higher. Of all the fundamentals we monitor, this is the most important one. As the new issuance market reopens, we expect to see this tested. More on this next month.
In the past, if one wished to see the first signs of stress and distress in economies, one needed to watch banks and their reporting on provisions. The emergence of securitization enabled us to monitor consumer behavior more carefully (for those of you who have seen The Big Short, we are referring to remittance data). Credit-card debt and car loans are normally the canary in the coal mine. Everything looks disturbingly good there now. We will provide you with an analysis of Q4 2022 bank reporting in the next edition.
This is of greatest concern. Not only have we barely seen any writedowns in this sector, there in fact has been little or no repricing of the credit risk premium within the less well-established pockets. This is one area where our concern is growing.
If and when we see a credit cycle take hold, we would expect to see it bite disproportionately in one or a small number of sectors. European banks are much talked about in this respect, but our view is that despite their history of problems, volatility, and the effect of a recession on European economies, the banks themselves appear robust. An increase in dispersion would be a welcome sign, and we have little doubt that volatility will persist in 2023, so this will help to shake the dispersion tree. If banks are not the sector to avoid, they will be one of the sub-asset classes to hold. For those building a barbell portfolio of fixed-income assets, you could do worse than to include an allocation to European AT1s from blue-chip banks.1
Comparison of yield and duration of credit classes
Sources: BofA Merrill Lynch, Credit Suisse
Data as of 31.12.2022
The shown yield to worst is calculated as of December 31, 2022, and does not take into account costs, changes in the portfolio, market fluctuations, and potential defaults. The yield to worst is an indication only and is subject to change.
Other potential candidates for that risky (or unloved) piece of the barbell include corporate hybrids and some of the more volatile areas of EM.2 The key is not to find something that is a consensus long, but rather to find something where the fundamentals are better than the current market perception. We will cover both of these next month as we articulate our idealized portfolio for 2023 and beyond.
Be it autos, TMTs,3 homebuilders, financials, or energy in 2020, there is almost always one sector that gets hammered and fundamentally reprices through a credit cycle. This sector sees higher defaults and lower recoveries, and subsequently carries scar tissue into the next cycle. This is a natural result of banks and other lenders having to focus on restructuring, recoveries, and turning off lending to those in-focus sectors for a period. Scanning across our portfolios, no single candidate currently jumps out at us. For that reason, we are maintaining a very disciplined portfolio management approach, avoiding anything that raises even a small concern. Now is not the time for irrational exuberance or hope.
CSAM Fixed Income Investment Strategy
Risk appetite – Investment Grade
For illustrative purposes only.
Source: Credit Suisse. As of 6.1.2023
CSAM Fixed Income Investment Strategy
Risk appetite – High Yield
For illustrative purposes only.
Source: Credit Suisse. As of 6.1.2023
In summary, against the backdrop of the inflation data and the recent positive market moves, we find ourselves maintaining a strongly bullish medium-term view on fixed income, but with a growing bias toward simplicity and liquidity.
We feel very uncomfortable stating such constructive views and fully expect to be able to give a much more nuanced and balanced view next month.
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