The Big Idea

Credit wins

| July 7, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Midway through 2023, with a Fed pulling levers to slow the economy, credit has turned in a surprisingly strong performance. Leveraged loans, high yield and investment grade credit and ABS have all led Treasury and agency exposures in both absolute and risk-adjusted returns. Of major credit sectors, only private CMBS has fallen down. Most portfolios managing for total return have longstanding overallocation to credit, and both current circumstance and market structure argue for keeping that in place.

Strong absolute returns to credit

Leveraged loans led major fixed income sectors in the first half of the year with annualized returns of 13.00% followed by high yield with 10.06% and investment grade corporate debt at 6.18% (Exhibit 1). ABS delivered an annualized return of 3.40%, agency MBS delivered 3.30%, agency CMBS delivered 2.89%, Treasury debt 2.88% and private CMBS finished at 0.91%.

Exhibit 1: Credit led fixed income returns in the first half of 2023

Note: Annualized daily returns from 12/31/22 to 6/30/23 based on Bloomberg indices, except for leveraged loans, which relies on the Morningstar/LSTA Leveraged Loan Index.
Source: Bloomberg, Santander US Capital Markets.

Reflecting modest changes in rates and spreads

The returns reflect the modest impact of rates across sectors and the much bigger impact of excess returns generated by the higher yields in credit, reinvestment of the excess cash flow and minor repricing from spread changes. Despite volatility in rates and spreads from January through June triggered by the Silicon Valley Bank collapse and its aftermath—the 10-year rate, for example, ranging from 3.31% to 4.06%—net changes in rates and spreads from beginning to end were modest (Exhibit 2). Rates dropped across the yield curve from beginning to end, and most spreads widened except in leveraged credit. High yield OAS tightened a minor 7 bp and the price of an average leveraged loan went up $0.92.

Exhibit 2: Modest swings in rates and spreads January to June

Note: OAS based on Bloomberg indices, except for leveraged loans, which relies on the Morningstar/LSTA Leveraged Loan Index.
Source: Bloomberg, Santander US Capital Markets.

And healthy returns to credit risk premiums

The modest swings in rates and credit meant most of the outsized return to credit has come from collecting risk premium. Yield spread, reinvestment and spread repricing contributed 64% to returns this year in leveraged loans, 82% to high yield and 50% to investment grade (Exhibit 3). Other sectors netted minor amounts of return from risk premium, with Treasury debt, by definition, getting none. Sharply wider spreads in private CMBS—struggling with the value of loans against commercial office space—fully offset the benefits of higher yield, creating negative excess return.

Exhibit 3: Excess return drove most of the performance in loans, HY and IG

Note: Annualized daily returns based on Bloomberg indices from 12/31/22 to 6/30/23, except for leveraged loans, which rely on the Morningstar/LSTA Leveraged Loan Index. Excess returns on leveraged loans calculated as the difference between the loan index and the ICE BofA 3-Month Treasury Bill Index.
Source: Bloomberg, Santander US Capital Markets.

Returns to each sector also depended on rate exposure, of course, with the magnitude tied to key rate duration. The most interesting example comes from the difference between leveraged loans and high yield debt. Since most leveraged loans float off 3-month LIBOR or SOFR, higher index rates added to returns. Most high yield debt is fixed-rate with an index duration that started January at 3.87 years, so modestly lower Treasury yields added modest rate returns to high yield.

With relatively low volatility for each unit of return

Beyond absolute return, the quality of the return to credit this year has also compared favorably. The ratio of annualized daily returns in each sector to the annualized standard deviation or risk taken to earn those returns shows credit performed efficiently—except, again, for private CMBS (Exhibit 4). Here, both returns and risk reflect all embedded risks including credit, prepayment, duration and other. Leveraged loans, for example, generated 6.41% in return for each unit of risk taken. High yield generated 1.88% largely due to the higher volatility created by its rate exposure. Investment grade corporate debt, with the longest duration and highest rate exposure in credit, delivered 0.83%. ABS delivered 0.88%. All other sectors delivered less than 0.40%.

Exhibit 4: Credit delivered strong returns for each united of realized risk

Note: Annualized daily returns from 12/31/22 to 6/30/23 based on Bloomberg indices, except for leveraged loans, which relies on the Morningstar/LSTA Leveraged Loan Index.
Source: Bloomberg, Santander US Capital Markets.

Supportive conditions and market structure

Although the Fed keeps trying to slow the economy, the economy has shown surprising momentum. That includes absolute corporate profits and, more importantly, profit margins. Although margins have declined since mid-2022, they remain well above pre-pandemic levels, supporting issuers’ aggregate ability to pay existing debt (Exhibit 5). Higher interest rates will almost certainly hurt margins for some companies, of course. But most investment grade issuers extended the duration of their debt at low rates in 2020 and 2021, insulating themselves from the rise in rates since. The most vulnerable issuers are funding unhedged with floating-rate leveraged loans. But even in that market, current gross coupons ranging between 8% and 10% provide healthy compensation for the risk of default and loss.

Exhibit 5: Corporate profit margins remain well above pre-pandemic marks

Note: data shows profit per unit of real gross value added of nonfinancial corporate business: Corporate profits after tax with IVA and CCAdj (unit profits from current production), Dollars, Quarterly, Seasonally Adjusted.
Source: Federal Reserve, Santander US Capital Markets.

Of course, credit would be vulnerable to a severe recession, but that seems increasingly unlikely.

The other important consideration for different fixed income sectors is market structure. In particular, the Fed and banks dominate the Treasury and agency markets while private capital dominates credit. For at least the next few years, capital that assigns policy value to Treasury and agency debt and MBS looks likely to keep investment returns to those sectors low. For private investors, there is likely more absolute return and better risk-adjusted return in credit.

* * *

The view in rates

OIS forward rates now put fed funds above 5.40% from September through February 2024. The same forwards also anticipate 100 bp of cuts in 2024. This is just the latest version of market pricing for a terminal fed funds rate, the length of the Fed pause and the pace of eventual cuts. The stickiness of core inflation suggests cuts in 2024 look premature. The Fed looks more likely to hold fed funds at a terminal rate well into 2024, something that would actually tighten financial conditions if nominal rates stayed constant and core inflation dropped. Under those circumstances, real rates would rise. That is likely the Fed plan.

Other key rate levels:

  • Fed RRP balances closed Friday at $1.82 trillion, the lowest level since April 2022. With the Treasury replenishing its cash balances after the resolution of the debt ceiling, even short T-bills trade above the RRP’s 5.05% rate, drawing cash away from the facility.
  • LIBOR officially went away on June 30, so goodbye, old friend. Setting on 3-month term SOFR closed Friday at 530 bp, up by 6 bp from two weeks ago.
  • Further out the curve, the 2-year note closed Friday at 4.95%. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is slightly above current yields. The 10-year note closed at 4.06%, up 32 bp over the last two weeks. With inflation likely to drift down and growth likely to slow, fair value on the 10-year note is lower than current yields.
  • The Treasury yield curve traded Friday afternoon with 2s10s at -88, steeper by 12 bp over the last two weeks. Expect 2s10s to reflatten as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s traded Friday morning at -31 bp, 13 bp flatter over the last two weeks.
  • Breakeven 10-year inflation finished the week at 227 bp, up by 6 bp over the last two weeks. The 10-year real rate finished the week at 181 bp, up by 30 bp in the last two weeks.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 147 bp, tighter by 11 bp in the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 172 bp, up 11 bp in the last two weeks. Par 30-year MBS TOAS closed Thursday at 67 bp, wider by 17 bp in two weeks.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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