Credit: Why Credit Quality Still Matters
HY default rates are likely to rise in the year ahead
Chief Investment Office, Daryl Ho2 Aug 2023
  • Market has turned risk on in anticipation of end of Fed hiking cycle
  • However, we do not believe investors should go down spectrum of credit rally to chase HY credit
  • Credit issuers have mitigated pressure of higher rates by extending duration of their bonds
  • For HY issuers however, pressure of refinancing and higher rates are likely to kick in come 2024
  • IG issuers remain better positioned due to stronger balance sheets & high interest coverage
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From hikes to holds. It is with cautious optimism that the markets digested the outcome of the July FOMC meeting, allowing some hope that the most aggressive rate hiking cycle in decades has come to an end. We share this optimism, keeping a mind a couple of observations:

  1. Divergence between short and long rates. Even as the interest rates across the curve were rising aggressively last year, there came a point near the end of 2022 where further increases in the policy rate had no effect on 10Y rates. Longerterm rates – which tend to look through short-term hiking cycles – began to signal that the absolute levels of rates would likely become a drag to the economy, implying that conditions were becoming adequately tight.
  2. Downgrade of US debt rating. More recently, Fitch (a credit ratings agency) downgraded the rating on US debt from AAA to AA+, citing growing government debt burdens and fiscal deterioration as reasons for the change. Rates should not push much higher from here, as it would only serve to aggravate these fiscal sustainability concerns, with risks that the US would never be able to repay their ballooning levels of debt if taxes are only sufficient to cover mandatory spending and interest expenses.

Time for credit risk taking? Markets have certainly cheered this perceived end of the hiking cycle, judging from the stellar performance of risky assets this year. For fixed income investors, the temptation is to leap into riskier High Yield (HY) markets given that (a) the headwinds of rate hikes are likely to abate, while (b) HY markets have generally outperformed Investment Grade (IG) this year. We, however, remain steadfast in our belief to stick to quality in one’s fixed income portfolio – noting that we are already in the later phases of the credit cycle; and as such, credit risks are likely ahead of us, not behind.

Figure 1: IG issuers are better insulated from rising interest rates, having extended duration

Source: Bloomberg, DBS

Duration extension mitigated the effect of higher rates. One reason why credit spreads had been so sanguine was the fact that corporate issuers had taken advantage of the zero-rates environment to lock in low funding costs for the long term. The average duration of IG issuers in the US peaked as high as 8.8 years during the low-rates environment of 2021, meaning that on aggregate, these companies would not face refinancing strain in their bonds for much of the remainder of this decade. Spreads have in a way reflected these benign risks.

The same however, could not be assumed for HY markets. We note that HY issues have on average half the duration of IG issues, as investors prefer not to have long duration exposure to junk risk. Moreover, these issuers did not meaningfully extend duration during the low-rate years of 2020-2021, implying that refinancing risk is likely approaching in the years of 2024-2025.

Quality is still key. Noting that HY default rates are likely to rise in the year ahead, we continue to reiterate a quality bias for a fixed income portfolio. Investors in a 60/40 balanced portfolio can reap the benefits of a pro-risk environment through their equity allocations, while bonds should continue to serve purposes of (a) downside protection and (b) steady income generation. On the back of the downgrade of US debt, we do not expect a wave of downgrades in IG credit, given that only two US corporate issuers have ratings in line with the sovereign (Microsoft and Johnson & Johnson); investors can take comfort that the best yield and safety balance still lies with IG credit in the 3-5year duration segment.

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