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The number of voices predicting a recession are growing. The UK economy contracted in the first three months of the year, while both the US and European economies are slowing.
When an economy is in recession, financial risks increase, including the risk of default, business failure, and bankruptcy.
For bond investors this is particularly pertinent. They want reassurances that any money loaned to companies will be paid back and that the coupon – or interest rate paid – will continue until the bond matures.
But the fact is, recessions often lead to a pick-up in defaults.
While a recession in the coming months is now a possibility, it is worth remembering that the last recession was only two years ago.
Does this mean that all the ‘bad’ companies have already gone out of business and therefore defaults will remain low? Or did the Covid-led government bailouts lead to an increase in indebtedness that will in turn lead to a bigger default cycle than usual?
We asked a few Elite Rated managers their views.
Grace Le, co-manager of Artemis Corporate Bond, says that with default rates around historic lows, it’s impossible to deny that we are due a pick-up in defaults. She said: “We expect default rates to rise from their current floor but with companies broadly in better shape than they were two decades ago, and governments’ willingness to resort to unconventional measures to prop up the wider economy, we don’t expect a meaningfully worse default cycle.”
M&G’s Public Fixed Income team, which feeds into the Elite Rated M&G Corporate Bond, M&G Strategic Corporate Bond and M&G Optimal Income funds, also believes default rates should remain low. “Even if the US/Europe slip into recession (as long as not long and severe which seems unlikely), we would expect defaults to remain low vs historic recessionary periods due to fundamental strength,” it said.
This is a view further supported by George Curtis, a portfolio manager at TwentyFour Asset Management, who’s Corporate Bond, Dynamic Bond and Absolute Return Credit funds are all Elite Rated by FundCalibre, agrees.
“While default rates are by their very nature backwards-looking, there are a number of reasons why we believe they will remain low even if we do dip into recession,” he said.
“Firstly, corporate balance sheets have strengthened significantly, and the vast majority of the high yield universe used the attractive funding conditions last year to ‘term out’ their maturity profiles. In fact, 2022 maturities in both US and European high yield equated to just 1% of their respective indices. Even 2023 maturities remain subdued, with the bulk of the “maturity walls” coming in 2025 or later.
“Secondly, consumer balance sheets are also at multi-decade strengths and are providing a buffer against the economic volatility and cost-of-living squeeze that we are currently seeing.
“Thirdly, previous recessions, particularly in the US, have been characterised by very large defaults in the oil and gas sector. Given where energy prices have spiked to in recent months, energy firms are posting record levels of earnings (the European energy sector collectively posted year-on-year earnings growth of over 200% in Q1 2022), and the capital allocation priorities of lower rated oil and gas companies in the US have become more rational over the last five years.
“Finally, we have just gone through a default cycle, so the weakest names within the high yield universe have generally left the market or reworked their capital structures.”
On this last point, Lesley Dunn, co-manager of Baillie Gifford Strategic Bond pointed out to us in a meeting recently that in 2020, as the Covid-pandemic hit, the market was predicting double digit defaults. However, the response from central banks was immediate and of a magnitude completely unexpected. It allowed a lot of firms to borrow at lower interest rate levels than they would have had access to normally.
This doesn’t mean that a lot of poor-quality firms were able to pile on more debt, according to Lesley. It was actually a number of very viable firms accessing extra capital during a period of severe difficulty. “The market wasn’t open for everyone, so those that should have gone bust would have done,” she said.
Ben Edwards, manager of BlackRock Corporate Bond fund, is a little more sceptical. While the vast array of support programs made available to individuals and companies by governments worldwide during Covid meant that far fewer businesses defaulted than would have been expected, he says that the hope that “creative destruction” has recently played out and will lead to a benign default cycle, in the next recession, is likely optimistic.
He believes that the era of unusually low defaults, driven by ultra-accommodative monetary policy, is over and more “normal” business and default cycles are returning.
Ben says the outlook will become increasingly bleak for those companies that are structurally challenged, poorly run or that have taken on too much debt with cyclical earnings, as central banks continue to withdraw liquidity from the global economy.
As interest rates have already started to rise, and bond yields are more attractive than they have been for some time, are opportunities starting to present themselves already for long term investors?
“When the rate hikes stop, and investors can once again value risk with some certainty, cheaper asset prices across credit and sovereign bond markets alike will represent an incredible opportunity set for investors seeking attractive returns,” said Dickie Hodges, manager of Nomura Global Dynamic Bond fund. “The opportunity is coming, and we are ready to pounce on it. We just need to remain patient for now.”
“While we cannot know for certain what is going to happen in the future, we can always look at what is already in the price,” added M&G’s Public Fixed Income team. “If many people are talking about a recession, then, most likely, this is already reflected in valuations, and we would argue that’s the case today.
“Parts of the fixed income market are already compensating you for a recessionary environment. Moreover, the all-in yield you get from investment grade corporate bonds is close to decade highs, presenting an attractive opportunity for yield buyers and for asset allocators too: the yield you now get from an average USD BBB corporate is the same as the earnings yield you receive from the S&P 500!”