By Andrew Jackson, Head of Fixed Income at Federated Hermes & Fraser Lundie, Head of Credit at Federated Hermes
After such a tumultuous 2020, who would have thought that I would summarise 2021 to you as “boring” for our fixed income portfolios? We entered the year expecting volatility from Covid aftershocks, and they did not materialise.
Or rather, I should say the renewed infection waves, record cases, supply chain disruptions, inflationary spikes, steepening rate curves, and the end of furlough support mechanisms DID materialise, but the market moves one would expect as a result did NOT. So will 2022 be the same, full of potential pitfalls but incredulously benign in performance?
We view some of the disruptions listed above either as temporary or reflective of the successful conclusion of government remedies; however, in regards to the inflationary pressures and associated rates moves, we are more concerned that there might be a more substantial reaction in 2022. The market has readily accepted the message from central banks that this ought to be transitory – and maybe it will be. But the mere possibility that it is not, and the reaction to that, is enough to be a major risk in our view. Likewise, the focus on the global healthcare emergency has detracted from geopolitical rumblings for the last couple years, but we would not be too surprised to see more destabilisation from headlines around Taiwan or Crimea – and emerging market debt could be an interesting area for us. Indeed, quite a few participants seem to still be relying on mean reversion for performance and they may be disappointed.
With all of this in mind, we will start the year with a slightly more cautious beta approach to credit risk but with a higher inclination to extract alpha from fundamental credit work. We also believe that anomalous pockets of illiquidity and complexity premia still remain available, and will maintain overweight exposures to those assets, such as CLOs. In certain areas of the credit world, dispersion has risen and not reversed post covid, and we view this as not only healthy but a potential source of opportunities to seek improving stories. Likewise, where dispersion has remained too narrow, we would seek to underweight those credits that are benefiting from the rising tide.
2022 will be a year that will reward diligence and discipline. As spreads remain compressed and until rates rise enough to provide sufficient yield, intrepid investors will continue to seek more risk to achieve their return objectives. And while it is possible that 2022 serves another year of steady performance, it is equally probable that those stretched balance sheets and leverage ratios, squeezed cash flows and interest coverage multiples get properly tested – and if this time the shock is less systemic or if the central banks and governments do not, or cannot, bail out the weaker credits again, the more discerning and less aggressive will definitely benefit. Complacency is the enemy. As I repeatedly tell our PMs and analysts, “Do your work.”
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Credit market fundamentals have seen an impressive rebound and are set to remain strong in 2022, with the reopening of the economy fuelling recovery in balance sheet health. Corporate earnings have exceeded expectations but are likely to exhibit more differentiation going forward. The distinction will be driven by supply constraints causing disruptions in some areas creating pressure on output growth and inflation, which we think is already beginning to bite.
This may transition the backdrop to more of a ‘muddle through’ one, where margin deterioration poses the primary headwind to credit fundamentals. This is unlikely to be enough to challenge the allocation case, but it may test the valuations currently reflected in more cyclical sectors, parts of emerging market debt, and in the lowest segments of credit quality.
The technical picture is more supportive for credit in 2022. Net supply is forecast to fall moderately from record levels posted this year. Strong cash balances will secure credit metrics and asset rotation is unlikely with only small rises in rates and central bank policy stimulus remaining highly accommodative. Dare we say it, but in light of the lofty valuations and ownership present in the equity market, combined with the very uncertain backdrop for government bonds, the lower beta and quality nature credit may see it being used more as a safe haven asset class.
The rise and rise of commodities, particularly oil and natural gas this year, has to some degree masked the continued importance of sustainability and ESG in the asset class. We expect this to be short lived and in the aftermath of COP26, to see a renewed drive toward an ever more nuanced marketplace – rewarding companies with a keener eye on climate related risks and opportunities through the lens of governance, strategy and risk management. Companies will increasingly have their decarbonisation strategies analysed, with science-based targets (SBTs) proving to be a good indicator that many are now signing up to via the SBT Initiative. Holistic financial and sustainability analysis is key to delivering positive outcomes. This can be aided through active engagement. As metrics and targets become better understood, so too will the differentiation between corporates, financials and sovereigns, leaving active asset managers with a wealth of opportunity to add value.
Going forward, we will continue to take an active, conservative approach to credit investing that uses detailed, bottom-up analysis of company’s creditworthiness and sustainability credentials – something we believe will help us seek out the opportunities that are so often overlooked,
