Fixed Income Update: Credit Market Fundamentals Call for Active Risk Management

Matt Freund, CFA, Christian Brobst, and Chuck Carmody, CFA

• A recession is not likely in 2023—credit remains available to most borrowers, the banks are systematically stable, and the labor market is strong.
• The market’s expectation of additional Fed hikes in 2023 is reasonable.
• Fundamentals for investment-grade and high-yield credit may look strong on the surface but have become more mixed and defaults are increasing, which makes selectivity and a bond-by-bond approach essential.

Following the surprising failure of three banks in the first quarter, the market was unsure whether the Fed would be able to stick to its stated policy prescription of higher rates for longer. Bank stress has often led to tighter lending conditions that magnify the impact higher rates have on the economy. Fast forward 90 days and systemic stability seems to have returned. Lending standards appear to have tightened, but the worst-case scenario has been avoided and credit remains available to most borrowers. While questions remain around bank profitability, weak banks are not considered a sufficient deterrent to change the course of Fed policy.

Labor market strength was notable, as all three non-farm payroll releases during the quarter beat expectations. Although jobless claims have been increasing slowly, they have yet to reflect the level of job losses that many feel will be necessary to bring inflation down to the Fed’s long-held 2% goal. When viewed in totality, we believe these conditions indicate that a 2023 recession remains unlikely.

During the first quarter, the market anticipated multiple Fed rate cuts before year-end. That timeline has been pushed further out, and futures now indicate an additional rate hike (or two) are possible, with no cuts before May 2024 at the earliest. Our team views the updated timeline as reasonable, although we still believe the risk is to the upside on both terminal rates and the length of time that policy is held in restrictive territory.

We do not foresee a reacceleration of inflation as the base case. However, we caution against claiming victory too early, as downward pressure on year-over-year (YoY) measures has benefited from large base effects from 2022 rolling off (Figure 1). In July, headline base effects give way to much lower hurdle rates from last year that could lead to higher YoY levels just as the Fed enters “the last mile” in its efforts to return price gains to 2%.

Figure 1. Higher year-over-year inflation levels are on the horizon as base effects wane

Source: Bianco Research, “Pivot Hopes Still Dominant,” January 12, 2023.

Fundamentals across corporate credit markets, both investment grade and high yield, have become more mixed. At first glance, headline numbers reflect considerable strength, but a closer look shows weakening performance from elevated levels. For instance, EBITDA measures in the high yield market show YoY growth of +7.5%. That appears to reflect significant strength, but if you remove the three strongest sectors of gaming/leisure, energy and transportation (which all benefited from strong accelerations off Covid lows), the YoY measure contracts ‑11.1%.

Management teams appear to be reacting to this deterioration, as we are seeing a simultaneous drop in both capital expenditures and cash return to shareholders while outstanding debt balances are unchanged. Market-wide leverage and interest-coverage measures (longstanding measures of overall credit strength) remain healthy. However, continued pressure on cash flows could lead to a reversal of recent trends, and we would expect wider spreads to emerge from such a development.

Defaults and distressed exchanges are increasing, trending back toward the long-term average of 3.5% on a trailing 12-month basis. Although balance sheets are starting from a position of relative strength, we expect continued pressure on top-line revenue growth and margins. If those materialize and persist, it is our view that the market is most likely to experience a more protracted default cycle than average, but one where defaults peak at lower levels.

Positioning Implications

The interest rate market has moved to what we believe is a more balanced representation of potential forward rate paths, and as such, the team took opportunities in the second quarter to extend portfolio durations. In Calamos Total Return Bond Fund and Calamos Short-Term Bond Fund, this leaves us neutral to slightly long. Duration is a less material driver of prices and returns in the high yield market, and Calamos High Income Opportunities Fund continues to be positioned short of benchmark durations.

In our estimation, credit spreads reflect too sanguine of an outlook. Although overall fundamental metrics are buoyant, unfolding trends are more concerning. As in the first quarter, when we warned against complacency, we are actively reducing exposure to credits we evaluate to be more exposed to a downturn in cyclical activity or a rapid deterioration of asset value and those with weak liquidity. We are maintaining allocations to select high yield issuers where we believe we are being well compensated for the risks taken as we follow our disciplined research process, which helps us identify value.