Corporate credit conditions are deteriorating, with the last of three key metrics “now flashing red,” according to a traffic light system used by Janus Henderson Investors.
The outlook for cash flow and earnings has been revised down in the third quarter, the $300 billion asset manager said on Monday. The other two measures — access to capital and leverage — were already red.
Conditions are deteriorating globally as central banks around the world raise interest rates in an attempt to tame inflation, pushing the cost of refinancing debt to an all-time high. They’re particularly bad in Europe, where rising energy costs are fueling a cost-of-living crisis that threatens to squeeze consumption and profits, leading to lower credit quality and ultimately more defaults. payment.
“What started as a liquidity-induced credit slowdown is likely to become a fundamental slowdown as credit quality is affected by central banks’ relentless pursuit to fight inflation,” Janus Henderson said in a report. . “It is prudent to position portfolios for recession, increased volatility and deteriorating credit quality.”
The ability of companies to make money and service their debt was previously seen as the sole pillar of support for credit markets in a year of record losses. Companies had strong balance sheets after taking advantage of pandemic support measures and ultra-low borrowing rates to push back debt maturities.
These buffers are eroding as economic risks increase, but there is no imminent risk of a crisis, according to the report. Janus Henderson prefers higher quality, non-cyclical companies. This echoes investors who have recently been drawn to the quality market, where multi-year yields are high and defaults are low.
The riskiest parts of the credit market are another story. Interest coverage – a measure of how well earnings cover interest expense on debt – could fall to a decade low for leveraged euro borrowers over the next six to 12 months, UBS Group AG strategists led by Kamil Amin wrote in a note. to customers last week.
And zombie firms, a term generally used for businesses unable to cover a single year’s interest with profits, have made a comeback in credit discussions this year.
“As interest rates and corporate cash cushions move in opposite directions, some companies will struggle to service debt,” Janus Henderson said in the report. However, “we see a shallower default cycle and this will help underpin a significant dispersion of performance across different industries and sectors – which presents challenges but also opportunities for investors.”
Traders are bracing for the latter indicator’s demise and increasingly pricing in the prospect of lower corporate earnings, Tom Ross, portfolio manager at Janus Henderson, said in a phone interview. Global corporate bond spreads have fully reversed their summer rally.
Yet strategists at Goldman Sachs Group Inc. have joined a growing chorus warning that credit markets are not sufficiently priced in to recession risks, calling investors “complacent”. The New York-based bank has added its voice to calls from PGIM and JPMorgan Asset Management flagging upside risks to credit premium yields as U.S. recession risks rise.
“We’re going through tough economic times and that could lead to higher default rates,” Ross said. “While we continue to see upgrades in some sectors, the rating outlook will absolutely deteriorate given the growth outlook.”
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